EU member states have until June 10, 2019 to transpose the Shareholder Rights Directive II (SRD II) into law. Much of this legislation brings member states in line with current UK legislation, and may not even go as far as the updated Stewardship Code due to be published this summer. Given the directive’s potential effects on stewardship and governance, the lack of coverage in the UK is notable as ESG issues become increasingly important to the investment industry.
Hermes Investment Management conducted a survey in February 2019 to understand European investors’ approach to SRD II. Despite the fact that 42 percent of those surveyed had not heard of the new directive, as many as 66 percent thought companies focused on ESG factors produce better long-term returns. ESG is more than just a trend in the market: it is a fundamental principle upon which investment professionals are basing many of their decisions. SRD II looks to bring aspects of good governance into law.
Full shareholder identification processes currently exist in only half of the EU member states, according to a 2017 report by the European Securities and Markets Authority (ESMA). SRD II looks to expand this ability to all member states. This is a helpful move toward a more transparent equity market, but it does not go far enough. Under the legislation, member states are permitted to set a minimum threshold of a 0.5 percent holding before a company can request shareholder identification.
The UK already has legislation in place for the identification of shareholders – this is a cornerstone of investor relations and share register analysis. Section 793 of the Companies Act 2006 allows shareholder identification at any time the issuer wishes. This is contrary to SRD II, which is applicable only to the general meetings of issuers. But the directive does not actually go as far as defining a timeframe for affected parties to abide by. The run-up to a general meeting could be argued to apply to different time periods. Such uncertainty in drafting is unhelpful.
The recent rise in activism and shareholders exercising their rights should be viewed as a good thing. Investors take an activist stance to push boards for greater efficiency, less complacency and maintained focus. Pursuing this course has the intended aim of increasing returns and improving business, so improving shareholder rights should help companies engage with shareholders on any issues where they wish to be involved, while avoiding hostile activists.
SRD II is stringent on the role of intermediaries, making sure they facilitate the exercise of shareholder rights and transmit information to shareholders. Both companies and intermediaries are required to pass information along the chain of intermediaries to shareholders efficiently. Likewise, this process is applicable to intermediaries passing information from shareholders on to the company, including facilitating voting at general meetings.
Working for the benefit of the shareholder is also the responsibility of the issuer, which must ensure shareholders are treated fairly and can have confirmation that their rights are facilitated. SRD II requires receipts to be sent to shareholders when they cast their votes electronically.
It may be tempting to view these rules as onerous and unfairly requiring expense on the part of intermediaries, but that should not be the case. It is good practice to pass information on to shareholders if a firm is acting as an intermediary for them, and issuers should be able to confirm whether a shareholder’s vote has been counted and recorded, especially with modern technology making the storage and availability of data easier than ever. Therefore, any extra expense for intermediaries and issuers due to these parts of SRD II is less a comment on far-reaching legislation, and more a comment on poor governance practice.
Transparency disclosure and obligations of investors and proxy advisers
The EU has taken a comply-or-explain approach to institutional investor and asset manager engagement policies. Both intermediaries must establish and comply with engagement policies, or present a ‘clear and reasoned’ explanation as to why not. This already exists in the UK in the form of the Stewardship Code. But under SRD II they will also be required to disclose various elements of their investment strategies (and how these strategies may affect performance) and any arrangements they have with one another. This contributes to greater transparency for investors, allowing shareholders to more quickly and easily find information and operate in an open and clear market.
SRD II will cause less fuss among asset managers and investors because market regulation and transparency have been growing over the past few decades, especially since 2008. Most noise may come from proxy advisory agencies, which will be required to disclose their codes of conduct, reporting on and explaining any departures from those codes. This is akin to the comply-or-explain requirement previously mentioned, but applied to an area of the market where transparency is not so widespread. Various elements of disclosure will need to be satisfied, all relating to the research, advice and voting recommendations that proxy advisers regularly provide.
Greater transparency around general meetings and proxy voting will be welcomed by most corporates. Proxy advisory agencies wield power over issuers because institutional investors understandably often follow their recommendations. But the onus must fall upon proxy advisers to disclose their methodologies and how they reach their conclusions.
In recent years, remuneration issues have made headlines, with many directors being challenged on pay packages perceived as egregious. These challenges have been increasing as governance comes increasingly into focus among investors. SRD II will give all shareholders the right to vote on remuneration policies. Such a vote will be either binding or advisory – a decision to be made by individual EU member states – but will nonetheless be an opportunity for shareholders to express their distaste or approval. This vote will be put to shareholders at least every four years, with any material change being put to vote at the next general meeting. There are seven defined criteria that the policy must include, so issuers have little room to escape publishing a full policy that shareholders can scrutinize.
Much like the UK’s regulatory environment, SRD II will require remuneration reports to be voted on annually – but this vote will only have to be advisory. While this means companies are not bound by the result, it does not mean they can ignore it. Such a course of action could be viewed very poorly by shareholders and likely backfire, with directors potentially not being re-elected. To ease the burden on small and medium-sized businesses, the legislation allows them to submit the remuneration report for a discussion rather than a vote, if the member state so wishes.
Failing on penalties
We expect SRD II to be welcomed by many issuers throughout Europe, particularly those in less transparent markets. Proxy advisory agencies will probably be less keen on its content, as it brings regulation to an area that is currently regulated by ESMA on a light-touch basis.
One area in which SRD II substantially lacks any substance, however, is penalties. Article 14b states that member states can lay down their own laws, with the only requirement being that the measures adopted must be ‘effective, proportionate and dissuasive’.
Therefore, the degree of severity of sanction to which breaches of SRD II will be treated will vary from country to country, creating an approach that is not uniform and therefore open to arbitrage. Member states will have the ability to attenuate the intentions of this law and may do nothing more than warn companies where there is a breach of the directive.
The lack of any substantial penalties for non-compliance may not necessarily produce the change in behavior that the directive intends.
Thomas O’Grady is marketing and business development executive at RD:IR