Institutional Shareholder Activism and The Code of Corporate Governance 2002

INSTITUTIONAL SHAREHOLDER ACTIVISM AND THE INSTITUTIONAL SHAREHOLDER ACTIVISM AND THE CODE OF CORPORATE GOVERNANCE, 2002 By Syeda Saima Shabbir, Research and Reference Officer, Supreme Court of Pakistan Institutional shareholders activism can play an important role in promoting good corporate governance activities in the listed companies of Pakistan. In developed countries like UK and US, much has been said and much has been done pertaining to the effectiveness of the institutional shareholders activism. However, in Pakistan very less research and work has been done in this respect. The main reason being that in Pakistan share ownership was mainly concentrated in the hands of individual investors whereas in developed countries this share ownership has moved from individual investors to' powerful institutions like pension funds, insurance companies and mutual funds etc. "Shareholders are often described as owners of corporations"' meaning thereby that owning shares in corporations tantamount to owning any other property. Shareholders being owners of corporations can play their part to discipline an unruly corporate system. Shareholders may be individual investors or institutional investors. "Institutional shareholders can be instrumental as agents of change towards improving corporate governance" 2. Institutional investors as compared to individual investors own large shareholdings in the investee companies and therefore they can have a better say in the managerial affairs of the same. Contrary to this, individual investors/shareholders owning small shares cannot influence the investee companies' affairs. The issue of shareholders activism was addressed exhaustively in the developed countries, particularly US and UK, after the occurrence of major corporate scandals like Adelphia, WordCom and Enron. These major corporate scandals served as an impetus to the promulgation of the Sarbanes -Oxley Act, 2002. The said Act is "considered to, be the most sweeping corporate governance regulation in the past 70 years and enhancing the long standing bandwagon for increasing the shareholder power", 3. Corporate scandals occurring in strong economies like US and UK, also triggered suspicions and doubts in the corporate environment of developing countries. Pakistan being one of them also felt a need to provide the country with such a legislation that could secure the rights and confidence of stakeholders. Therefore, in the year, 2002, the Code of Corporate Governance was issued by the Securities and Exchange Commission of Pakistan (SECP) "....to establish a framework for good governance of companies listed on Pakistan's stock exchanges" 4. After the issuance of the Code, all stock exchanges of the country were directed by the SECP to incorporate the provisions of the Code in their respective listing regulations, which was done accordingly. Corporate Governance in the broader sense postulates the way in which corporations are governed in accord with "the highest prevailing standards of ethics and efficacy upon assumption that it is the best way to safeguard and promote the interests of all corporate. stakeholders". 5 Institutional stake holders/investors having an influential force can shape the corporate governance of the investee companies by demanding the implementation of these standards of ethics and efficacy. Cadbury Committee (1992) viewed the role of the institutional investors by making the following observations:-- "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" 6. Similarly, Greenbury Report (1995) observed that 'The investor institutions should use their power and influence to ensure the implementation of best practice as set out in the Code" 7. On the same lines it was observed in the Harnpel Report (1998) that "It is clear....that a discussion of the role of shareholders in corporate governance will mainly concern the institutions". The observations made in all these three reports manifestly emphasized the influential role of institutional shareholders pertaining to the enforcement of good corporate 1 governance standards. The general law prevalent and applicable to all the companies in Pakistan is the 'Companies Ordinance, 1984'. Stock exchanges are regulated by the 'Securities and Exchange Ordinance, 1969' and the 'Securities and Exchange I Commission Act, 1997'. For Banking Companies, the legislators have provided the 'Banking Companies Ordinance, 1662%1 Similarly other legislations include 'Modaraba Companies and Modaraba (Floatation and Control) Ordinance, 1980', `Insurance Act, 1938', Insurance Ordinance, 2000', 'Listed Companies (substantial Acquisition of Voting Shares and Take-overs) Ordinance, 2002' and the like. There are so many laws prevalent in the country yet the environment for corporate governance is not healthy. The reason being that many laws overlap, others lack proper amendments and implementation. MEASURES TO IMPROVE INSTITUTIONAL SHAREHOLDERS ACTIVISM AND CORPORATE GOVERNANCE OF THE INVESTEE COMPANIES Governance of the Investee Companies The Securities and Exchange Commission may take the following measures to improve institutional shareholders activism and corporate governance in the investee companies; (1) Supervisory Board The Code of Corporate Governance for listed companies in China provides for the establishment of a 'Supervisory Board'. According to clause 59 of the Code "The supervisory board shall supervise the corporate finance, the legitimacy of directors, managers and other senior management personnel's performance of duties, and shall protect the company's and shareholders' legal rights and interests".9 . In the same line the Code of Corporate Governance of Pakistan may prescribe the establishment of a supervisory board which should conduct the supervision of managers, directors and auditors. The financial matters of a company should be open for supervision and examination by the supervisory board. The supervisory board of a company should comprise of those persons as members who are well acquainted with the existent corporate laws and procedures. The supervisory board should be governed by standardized rules and procedures inculcated in the articles of association of a particular company. The supervisory board should act as a bridge between the Company and its shareholders. The supervisory board should be in a position to make consultation with the institutional as well as individual shareholders with respect to the settlement of issue creating conflict of interests. The supervisory board shall be able to convene its meetings periodically. These meetings should be attended by the directors, managers and the auditors to discuss important matters of the investee company and to answer queries made by the board. In Annual General Meetings the recommendations of the supervisory board should be taken into consideration. The supervisory board can improve the corporate governance of the investee companies, if it is empowered to report directly to the regulatory authority, any violation of law by the company or its officers. The establishment of a supervisory board will improve transparency of financial reporting and will curb corruption in the management. (2) Corporate Strategy Committee The Code of Corporate Governance of China also speaks of a "Corporate Strategy Committee". Clause 53 of the Code postulates that "the main duties of the corporate strategy committee shall be to conduct research and make recommendations on the long-term strategic development plans and major investment decisions of the company". 10 The establishment of a corporate strategy committee by the companies will be a novel concept in Pakistan; however, it will improve the overall efficiency of the companies. In foreign countries every governing entity has a department for the research work. The corporate strategy committee should comprise of members from senior management of the company and professional researchers having experience in the corporate research. If every listed company also hires a professional for the research of up to date corporate laws, procedures, rules and regulations from local as well as foreign jurisdictions, then it will bear direct impact upon the improvement of corporate governance standards. The corporate strategy committee should be able to assess the impact of prevalent corporate laws and regulations upon the working of the company. It should point out any rigidities or flexibilities in the laws. The committee should be able to propose measures that may be taken into consideration by the corporate regulators while formulating new laws and policies. The company's overall assessment as to the compliance with the corporate laws and procedures should be made by the corporate strategy committee and default on the part of the company should be reported to the regulatory authority. (3) Negotiations with the Investee Companies The 'Combined Code on Corporate Governance, 2008' Inc emphasized the need for dialogue between the institutional investors and the investee companies in the following words:-- "Institutional Shareholders should enter into a dialogue with the companies based on the mutual understanding of objectives."11 There is a good example of a settlement of directors' remuneration issue through a constructive dialogue between tilt, institutional investors and the investee company. In 2002, the institutional investors having large shareholdings in the Kingfisher plc (a UK based international retailer) severely criticized the directors' remuneration packages announced by the company. The company encouraged dialogue with its institutional 'investors and entered into a compromise with them whereby the remuneration terms were revised according to the demands of the institutional investors.20 Major controversies can be resolved through mutual consultation and deliberation. The Code of Corporate Governance of Pakistan does not speak of any dialogue or mutual understanding between the institutional investors and the investee companies'. Therefore, the Code should specifically incorporate a particular clause to this effect in its provisions. Inserting such a clause in the Code will provide a specific way to the investors to solve their disputes and problems through negotiations first instead of invoking legal provisions. The institutional investors may get aggrieved of any particular decision of the board, excessive remuneration of the directors, undue favour to some investors or lack of transparency and disclosure policies. To settle all these issues, a dialogue between the investee company and the institutional investors will be a more prudent option. (4) Responsibility to Vote by Institutional Investors The institutional investors in Pakistan usually do not prefer to vote and keep themselves aside from the governance affairs of the investee company. Such a practice should be discouraged and they should be bound legally to cast their votes. Institutional investors being major shareholders of the investee company, by effectively exercising their voting plover, can turn the tide of any unfavourable decision taken up by the management. Non-exercise of voting power by the majority shareholders, in fact allows the management of the investee companies, to commit malpractices and severe irregularities by making decisions detrimental to the shareholders' interests. In UK, the institutional investors have been encouraged specifically to exercise their rights of vote. The 'Combined Code on Corporate Governance, 2008' UK, in section 2 clause E.3 specifically places a responsibility upon the institutional investors to use their right of vote in the following words:-- "Institutional shareholders have a responsibility to make considered use of their votes Institutional shareholders should take steps to ensure their voting intentions are being translated into practice. Institutional shareholders should, on request, make available to their clients information on the proportion of resolutions on which votes were cast and non discretionary proxies lodged. Major shareholders should attend AGMs where appropriate and practicable. Companies and registrars should facilitate this."2' In the Code of Corporate Governance of Pakistan, the role of the Institutional investors has not been defined specifically. Moreover, no such clause pertaining to the exercise of voting power by the institutional investors has been inserted by Code. Active participation by the institutional investors in the investee company's affairs can be expected only when a sense of responsibility to cast their votes, is created through legal provisions. The Securities and Exchange Commission of Pakistan in order to enhance the role of institutional investors in the corporate governance of the investee companies should allocate a separate section to the 'Institutional Shareholders Activism' in the Code of Corporate Governance. Voting by the institutional investors should be encouraged by inserting a separate clause titled 'Institutional Shareholder Voting' in the code of Corporate Governance. Non-exercise of voting power by the institutional investors should be curbed by way of imposition of penalty in the shape of fine etc. Moreover, electronic voting system should also be introduced instead of a paper based system, in order to ensure more transparency of the voting process. (5) Council of Institutional Investors. The Securities and Exchange Commission of Pakistan established the 'Institute of Corporate Governance' under section 42 of the Companies Ordinance, 1984. The purpose of establishment of the institute is to promote healthy corporate governance practices in Pakistan. The Commission should also establish a 'Council of Institutional Investors' in Pakistan. In America the Council of Institutional Investors is working as a non-profit association. The Council has been established there with an aim to provide information to the public, investors, and the policy makers about good governance practices. In Pakistan as well such a council should be established to rejuvenate and strengthen corporate governance practices. The Council shall act as a non-profit association and the institutional investor foreign as well as local, making investments in Pakistani equities, must be given membership. The Council should held conferences of the institutional investors periodically in order to create awareness about corporate governance system and exercise of activism by the investors. Experts in the field of corporate law should also be participants of such conferences, so as to point out weaknesses in the prevalent laws and to suggest the measures that could be taken up by the corporate regulators. The Council shall grant membership to all the institutional investors of the listed companies. The Council of Institutional Investors should encourage investments by the institutional investors local and foreign, in all the three stock exchanges of the country. The Council should call its annual meetings to discuss the problems faced by the institutional investors in the corporate sector. The Council should be empowered to collect data of the institutional companies and the investee companies and to report to the SECP and violation of corporate 'governance norms by the investing and the investee company. Proper record of the poorly performing Companies should be maintained and they should be kept on 'focus lists'. The company giving poor performance should be held answerable through explanation and imposition of fine. In America the Council of Institutional Investors is playing a significant part in enhancing the corporate governance role. The Council occasionally holds seminars, to educate investors and the public about corporate governance principles and standards. It also solves the issues concerning the investments and shareholders rights. In the same line, the establishment of a Council of Institutional Investors in Pakistan, will bridge the gap between the Board and the investors. It will also enhance the confidence of the general public in the institutional companies. The Institutional investors owe fiduciary duties towards the public as they hold the public money. It is, therefore, incumbent upon them to protect the interests of the public by making prudent investments. The Council, if working, effectively can arouse the passive institutional investors' souls and could lead them towards activism in Pakistan. The seminars and conferences held by the council will benefit the institutional investors in educating them about demanding the implementation of sound corporate governance practices. The Council will also help in pointing out irregularities committed by the investing and investee companies in the compliance of prevalent laws and procedures. Primary objective of the Council should be to encourage the Institutional investors to become activists in order to ensure that the shareholders interests are not put at stake while taking corporate actions. The Council of Institutional Investors will observe the prevalent corporate laws and will make recommendations to the Securities and Exchange Commission of Pakistan to update the laws and policies according to the market requirements. The establishment of a Council of Institutional Investors in Pakistan will give stability to the capital market thus contributing towards the robust growth of the corporate sector. (6) Mandatory Independent Directors The Code of Corporate Governance of Pakistan in para 1(b) provides for the appointment of atleast one independent director representing the institutional investors. The said clause of the code reads as follows:- "The Board of Directors of each listed company includes at least one independent director representing institutional equity interest of a Banking Company, Development Financial Institution, Non-Banking Financial Institution (including modaraba, leasing company or investment bank), mutual fund or insurance company.22 The Code although provides for the appointment of an independent director by the institutional investors, however, this provision is voluntary and not mandatory. In order to ensure more transparency, it is the need of the time that the Code shall compulsorily obligate the appointment of independent directors representing the institutional investors. Moreover, institutional investors being major shareholders of an investee company shall be given more representation by appointing at least three directors instead of one. The reason being that just one independent director on the Board cannot make any decision singularly if all the other directors of the board are against him. (3.2.7) Legal and Accounting Experts The Code of Corporate Governance, 2002 should encourage the listed companies to employee legal and accounting experts. Legal and financial diligence will be expected of these experts in assessing the investee company's record in compliance with the prevalent laws, rules and regulations. These experts should be in opposition to advice the investing as well as investee companies to adopt legal and accounting standards of international level in order to improve their overall efficiency. (3.2.8) Mandatory Educational Qualification and Certification for Directors There is no minimum educational qualification for a person to act as a director of a listed company in Pakistan. Neither the Companies Ordinance, 1984 nor the Code of Corporate Governance, 2002 prescribes any educational qualifications for the office of directorship. The office of directorship is a very responsible office and for the efficient working of the same the directors must be highly educated and experienced. Directors with proper educational qualifications and professional experience will be in a better position to implement the corporate governance principles and standards in their true perspective. Uneducated and non-professional persons acting on the posts of directors cannot act with rationality anti prudence, resultantly putting shareholders investments at stake. Therefore, special provisions should be made in the Companies Ordinance, 1984 and the Code of Corporate Governance, 2002, prescribing the specific educational qualification and experience for the office of directorship. The law should also provide for mandatory certification for directors including mandatory training and examinations with an aim to improve competency of the directors. There is a dire need for certification of the directors in order to equip them with the corporate laws and practices in Pakistan. The Institute of Corporate Governance already working in Pakistan, should strive to properly train the directors in the field of corporate law. Non-attending of trainings and non-passing of examinations should disqualify a person from acting as the director of a listed company. Mandatory certification for the directors will help in reducing the corporate failures and will strengthen the accountable and professional role of the directors. The requirement of minimum educational qualifications for the investing as well as investee companies should be the same. Institutional investors with more experienced and well educated directors will show more activism. (9) Effective Monitoring By the Institutional Investors The effective monitoring of an investee company's performance by the institutional investors is pertinent for increased activism. This activism may be exercised by the institutional investors by periodically considering the annual accounts, board structure and audit reports of the investee company. The institutional investors should attend the meetings of the investee company regularly and should make effective exercise of voting power. They should also ensure that the independent directors are representing their true causes. They should also ensure that their proposals have been presented in the meetings of the company properly and have been taken into consideration while solving contentious issues. An effective monitoring of the investee company's performance will identify the controversies at any initial stage and will maximize the shareholders' wealth. (10) Effective Internal Controls An effective internal control system is necessary for the smooth functioning of a corporate entity. External controls can work easily when the internal control system of a company is strong. In US, the Sarbanes-Oxley Act of 2002 particularly requires in section 404 that the companies should publish in their annual reports about the effectiveness of the internal control systems. In Pakistan as well as the companies whether small or large should be made responsible for furnishing information about their internal control systems in the annual reports. Specific provisions to this effect may be introduced in the Code of Corporate Governance. (11) Removing Legal Constraints As discussed earlier the legal environment in Pakistan is not conducive for institutional shareholders activism. In order to ensure proper representation and increased activism by the institutional investors in the corporate sector, laws and policies need to be reviewed. Legal hurdles need to be removed and laws should be made flexible to give more room to the institutional shareholders activism. The Companies Ordinance, 1984 needs to be amended and updated, inserting stringent provisions for violation of corporate governance norms. Similarly various rules including the 'Investment Companies and Advisors Rules' 1971, 'Asset Management Companies Rules, 1995 and 'Prudential Regulations for Modarabas' 2000 also require necessary amendments in order to bring more investments by the institutional investors on stock exchange. The Code of Corporate Governance, 2002 should be reviewed by the Securities and Exchange Commission of Pakistan and provisions relating specifically to the role of institutional shareholders in the corporate governance may be inserted. Moreover, as discussed earlier, provisions pertaining to educational qualifications for directors and their mandatory certification, establishment of corporate strategy Committee, Council of institutional investors, supervisory board, effective monitoring, mandatory independent directors and responsible voting should be made in the Code. Other regulations and policies lacking in ensuring proper compliance of corporate governance policies, should be reviewed in consultation with the legal and corporate experts. Passive behavior on the part of shareholders should be discouraged. Prudent rules and procedures should be laid down to attract more institutional investments from foreign as well as domestic investors. There should be an attitude of zero tolerance by the corporate regulators, for the violators of the Code and prevalent corporate laws. Strict actions should be taken by the Commission and the Courts, against the management and the companies concerned for any contravention of the law. Strengthening of the legal tools can bring stability to the capital market and restore the investors' confidence. 1. A.G. Monks and N. Minow, Corporate Governance, p.98, England: Blackwell Publishing 2004. 2. http://www.secp.gov.pk/divisions/Portal CS/PDF/WORKING% 20 PAPER pdf. (accessed May 4, 2009). 3. Moshe Pinto, The Role of institutional Investors in the Corporate Governance", page 1 (PhD diss, University of Hamburg and Bolonga .2005).. 4. httwww.secp.gov/dp/pdf/manual-CG.pdf.(accused January 24, 2009) 5. Supra note 4. 6. Sir Andrian. Cadbury, Report of Committee on the Financial Aspects of Corporate Governance (London: Gee & Co. Ltd., 1992). 7. Sir Richard Greenbury, Directors Remuneration (London.: Gee & Co. Ltd., 1995). 8. Sir Ronnie Hampel, Committee on Corporate Governance: Preliminary Report (London: Gee & Co. Ltd., 1997). 9. www.csrc.gov.cn (accessed Aug 17, 2009). 10. Supra note 9. 11. www.frc.org.uk (accessed Aug 20, 2009). 12. Christine. A. Mallin, Corporate Governance, p.95, Oxford University Press Inc. New York, 2007. 13. Supra note 11 14. wvvvv.secp.gov.pk/corporatelaws/pdf/Code of Corporate Governance, pdf (accessed August 5, 2009).