Rajiv Jaitly was one of the experts appointed by the Office of Fair Trading on its expert panel for its market study on defined contributions work place pensions in the UK.
The report which was published in September 2013 contained a number of recommendations that government and industry are currently working on.
To read the full report please click here.
©Jaitly LLP
The latest missive to emerge from the European Union in its effort to control the risks that banks pose, has been to curb the amount of bonus that can be paid to the employee of a bank. We have yet to see the detail of how this will operate in practice and what loopholes might be identified to maintain the earning power of executives, but the creation of this restriction is a reflection of the impotence of shareholders in large businesses to exercise their rights as owners of these businesses.
To a large extent this impotence has arisen because those that exercise the shareholders’ powers whether through proxies or directly, tend to be financial institutions themselves, with similar interests and conflicts. These financial institutions are not the ultimate owners of these interests because the chain of ownership extends even beyond pension vehicles – often identified as the largest owners of equity around the world – to the wider general public, who have little awareness of this. This means that items such as remuneration get waived through without too much challenge – because market practice is accepted as the status quo.
But governments as investors have also been reluctant to challenge the status quo. The reasons for this are less clear because as significant and controlling shareholders, they can very easily replace a board that was not acting in their interests. But they have chosen not to flex their muscle in this manner. This can in part be explained because governments as shareholders are also primarily interested in the value of their shareholdings upon exit, rather than income, because this is how an assessment will be made on the success of the government’s strategy and how much it will have ultimately cost the tax payer to bail out ‘too big to fail’ institutions.
In a capitalist economy, wealth creation needs to be rewarded. Shareholders as owners of businesses should be free to choose how they remunerate and reward those who work for them. The nature of shareholding has however, changed over the years. Shareholders have gradually become a fragmented body of owners and this inability to act collectively in their own interests has resulted in them ceding their ability to influence outcomes, so that executives in a business have been able to reward themselves handsomely before passing on any income to shareholders. These executives of course have an interest in the capital value of shares – to which they do pay keen attention – but true income generation for them as stakeholders, as opposed to capital wealth, has been through bonuses rather than the declaration of dividends.
The nature of capital markets has therefore changed fundamentally in this respect with the balance of power shifting to the executives. Shareholders have only themselves to blame in allowing this to have come to pass, but this is largely because the nature of share ownership has changed. Shares increasingly function as instruments to measure capital value whether for secondary trading, price discovery and transparency or as exit strategies for investors and entrepreneurs rather than for primary capital raising or as income generating assets. Of course the shareholder base has also become disparate so that collective action against a board has become more difficult. Regulations surrounding take-overs such as in relation to concert parties, complicate matters further.
Activist investment managers recognise this and use their shareholdings in an effort to rectify the imbalance of power that they see – but they too are generally short term investors looking to extract value for their own investors in order to earn management and performance fees.
Difficulties around the regulation of public primary offerings have also resulted in capital being raised through means other than equity and there is increasing use of shadow banking structures and private equity type deals which make expensive charges for these facilities and take company assets as collateral to protect their interests.
Where shareholders are actively engaged in the remuneration process there should be no need for ceilings to be imposed on remuneration. The chances are that such regulations are likely to drive these remuneration structures offshore to non EU locations and make transparency on these matters even more opaque than they currently are. Rather than trying to regulate remuneration arrangements, it seems more appropriate to think about how investor engagement can be rekindled to become a more valuable process than the self serving interests of institutional investors who are only acting on behalf of the ultimate owners of these assets.
As ever the devil will be in the detail.
The basic intention of the rule is to curb excessive risk-taking. The European bureaucrats have decided that this can be controlled by imposing a basic salary-to-bonus ratio of 1:1 but permitting this to be raised to a maximum of 1:2 with the approval of shareholders. This higher ratio would require the votes of at least 65% of shareholders owning half the shares represented, or of 75% of votes if there is no quorum.
In order to encourage a long-term view, if the bonus is increased above 1:1, then a quarter of the whole bonus will be deferred for at least five years.
In order to come into effect, this proposal must be approved by member states and the European Parliament plenary. The vote is expected to be taken in the April 2013 session. If approved, member states would need to include these rules in their national laws by 1 January 2014.
If the vote results in approval for the proposal, then the second half of 2013 may provide some interesting restructuring opportunities for lawyers as they consider how these restrictions need to be addressed by their clients.
©Jaitly LLP
Financial Services have lost a lot of credibility since 2007 some of which can be attributed to their failure to manage conflicts of interest. That failure reflects unfairly on the many in financial services who strive to work decently and fairly and is something senior management in these businesses must take responsibility for.
Conflicts of interest are a fact of life and if recognised and managed properly can avoid many of the problems that have been the cause for criticism. Recent regulatory action against some of the big names in financial services both in the UK and US highlight that just because entities are regulated does not mean that they necessarily behave appropriately. Nor does ‘big’ give any indication of respectable behaviour – indeed the reverse might be a justifiable conclusion.
Yesterday the Financial Times reported on a study on mutual fund families conducted by researchers Goncalves-Pinto and Schmidt at the National University of Singapore and Emory University respectively, which reviews how cross trades occur in funds managed by the same investment manager. Often the ability for such transactions to occur will be of benefit to investors in both the buying and selling funds, but this may not always be the case where the manager is forced to look for liquidity to meet redemption requests when the assets in the portfolio are illiquid (and difficult to value). We have in earlier published Reflections looked at how this can happen in a fund of hedge funds where inflows into one vehicle can be used to meet the liquidity requirements arising from outflows in another vehicle. In such a scenario the cross trade may not necessarily be in the best interests of the subscribing investor but it helps the investment manager preserve its reputation with the redeeming shareholder at the expense of the incoming investor in an unrelated fund.
The evidence on the failures to manage these conflicts of interest continue to mount.
In November this year the UK Financial Services Authority (FSA) published a paper called “Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks.” This looked at a few specific areas that are worthy of examination by any investor looking to invest money with an investment manager:
The work done by the FSA was in the form of a thematic review of a selection of asset management firms visited between June 2011 and February 2012. The FSA concluded that “most of the firms visited could not demonstrate that customers avoid inappropriate costs and have fair access to all suitable investment opportunities.” That is a worrying statement given that these firms are obliged to observe rules such as on treating customers fairly. Yet it is not altogether surprising, given the attitudes of some boards in financial services to regulatory fines being nothing more than a cost of remaining in business.
Some of these firms had not even reviewed their conflict of interest arrangements since 2007 which also begs the question as to what their compliance departments had been doing following the credit crisis and the headline regulatory actions that had occurred since? The suspicion that asset managers are reverting back to bad old habits is hard to overcome in the face of such evidence.
The FSA has asked the boards of asset management firms in the UK to discuss the findings of the FSA paper and to then complete and return to the FSA an attestation by 28 February 2013 which confirms that the firm’s arrangements are sufficient to ensure that the firm manages conflicts of interest effectively and in compliance with the FSA rules.
Of course all firms are likely to comply with the FSA requirement. But a regulator’s demands will not change attitudes on their own. A firm’s culture – as the FSA points out – is central to the firm identifying and genuinely managing conflicts of interest. But it also requires investors to actively demand evidence on these matters and to not accept asset managers assurances at face value. That needs institutional investors with some determination to ensure that matters are set right and managed properly.
The standards of control over payments from customers assets are rarely the same as the standards of control asset managers exercise over payments made from the asset manager’s own resources. Investors need to ensure that they understand what is being paid for with their assets.
Personal dealing policies and gifts and entertainment are generally better managed as conflicts of interest.
Investors should question how asset managers allocate trades between different clients and how cross trading is controlled between funds they manage. The FSA has reported that it took enforcement action against a firm that had traded for one fund in order to ease the liquidity problems faced by another fund. My own experience and the university research referred to above indicates that this issue is a lot more widespread than the regulatory action against one firm would suggest.
The FSA also noted the practice particularly amongst hedge fund managers of using contractual limitations for liability to customers from errors in the absence of gross negligence and for not reporting these and collecting information on them. Of course under English law gross negligence is considered a “vituperative epithet”. The FSA note that repeatedly making the same error or similar errors might itself amount to gross negligence. The standard applied in English law to such a test may not be quite what the asset manager thinks they might be able to get away with.
So there is a lot that investors should be thinking about when it comes to their investment manager managing conflicts of interest. Notwithstanding the regulated nature of investment management it is worth investors continuing to monitor how investment managers identify, report and manage these conflicts.
©Jaitly LLP
The regulators on both sides of the pond have been active. Barclays, Knight Trading and now Standard Chartered have all found themselves squarely in the regulator’s sights.
The impact of all of these is serious to anyone running any sort of investment business.
One needs to overcome a lot of inertia to move an account or to move to another organisation – deposit guarantees not withstanding. And lets not kid ourselves – customers ultimately pay for these fines because these organisations keep a tight eye on the bottom line and find ways of recovering these costs. But fund boards do need to look at their service providers regularly to assess whether they remain appropriate and to spread risk if necessary.
Large businesses that can afford to do so will settle with the regulators quickly to try and limit reputational damage. e.g. Standard Chartered are already reported to be in settlement discussions in the US and today there have been reports that settlement has been reached to the tune of £217m. At least now we know how much a US banking licence costs as that is what has been preserved by reaching a settlement ahead of the hearings that were scheduled!
But a settlement of a regulatory action should not be the end of the matter for a fund board. It should consider whether the checks that will be carried out by a service provider remain appropriate and adequate and they should if necessary seek reassurances from them regarding exposure to any risks that arise as a consequence.
There are still a number of regulatory changes that have the potential to impact funds – the AIFMD rules have yet to be finalised and there have been changes to the CFTC exemptions which boards need to keep abreast of. It is important that they check back with the fund lawyers to understand what the impact of all these changes will be on the fund.
It is clear that the regulators have been focussing on ‘know your client’ type procedures and the extent to which these have been carried out in addition to the robustness of operational procedures.
Operational issues too are important, particularly in how brokers and investment banks are segregating and handling client assets and executing trades. IT change processes are often underestimated in terms of business impact as was demonstrated in the recent problems that the Royal Bank of Scotland had with its system upgrades.
In the meantime the best that a fund board can do in interpreting the emerging regulatory signals is ensuring that the disclosures to investors remain accurate and relevant and that their service providers are responding to the changing environment and have adequate disaster recovery processes that are updated and tested regularly.
©Jaitly LLP
