The Stewardship Code: institutional investors comply or explain

December 14, 2010

Originally published on

Compared to some of the high profile regulatory changes afoot, e.g., the Remuneration Code; Securities and Exchange Commission registration; and the Alternative Investment Fund Managers Directive, a new Financial Services Authority conduct of business rule that became effective today has received comparatively little attention. As recommended by the Walker Review on Corporate Governance, a regulated entity that manages assets on a discretionary basis for "professional clients" (as defined by the FSA, but including collective investment schemes, insurance companies and pension funds) must disclose clearly on its web site its commitment (or otherwise) to the Financial Reporting Council's Stewardship Code. The code seeks to close the lacuna between beneficial owners of companies and their managers by promoting better dialogue between shareholders and the boards of investee companies.

This new requirement serves as a further illustration of the increasing emphasis on appropriate corporate governance in the financial services sector and acknowledges that external institutional investors are a significant stakeholder through the manner in which they interact with or seek to change the management of investee companies.

The code

The objective of the code is to improve the relationship between institutional investors and their UK-listed investee companies. The seven principles of the code cover a variety of issues, including: collective action with other investors, monitoring of investee companies, voting policy and disclosure, and the management of conflicts of interest. Although the requirements of the code will not be new concepts, regulated firms must now make public matters that previously remained confidential, or explain their alternative approach. The requirement will not create additional reporting requirements to the FSA, nor will it form part of the FSA authorisation process. The FRC retains responsibility for monitoring commitment to the code and encourages those asset managers who have made the commitment disclosure to notify it, so that the FRC is able to publish a list of those organisations that have published their statement of commitment to the code.

It is something of a paradox that adherence to the code is not compulsory but the new FSA rule in COBS 2.2 makes disclosure of the regulated firm's commitment to the code mandatory. The alternative is to explain the firm's alternative business model, i.e., by explaining why elements of the code have not been complied with. In the case of the latter, the FSA acknowledges that there are trading strategies under which the manager may not engage with the companies in which they invest, if this is so then the firm's disclosure would merely need to explain this and could be along the lines of, "due to the client's selected investment strategy there is no engagement with investee companies and the client's would not expect such engagement". When a firm is following different investment strategies for varying clients it will need to identify to which clients/strategy its general disclosure statement applies. The disclosure, the argument goes, will assist the investor in making their investment decision, while acknowledging that engagement with investee companies is one of many possible investment strategies from which the investor can choose to meet its objectives.

Does it apply?

Those firms that do not manage investments for professional clients or manage investments only in relation to venture capital business escape the disclosure requirement. It would, therefore, not apply to a pure investment advisory business either. If the firm is permitted to manage investments on a discretionary basis for professional clients (the definition of which includes collective investment schemes insurance companies and pension funds) but in reality does not do so, deleting the managing activity from the firm's scope of permission would result in the disclosure requirement falling away. Equally, if the firm's business is limited to venture capital business, then applying to the FSA to have that specific limitation placed on its scope of permission would also remove the need to disclose compliance (or otherwise) with the code.

What needs to be done?

The regulatory impact of this new rule and the resulting disclosure requirements varies from firm to firm. An algorithmic or "black box" trader would be able to explain their non-adherence to the code on the basis that the strategy does not provide for shareholder engagement. At the other end of the spectrum is an activist hedge fund manager who is agitating for change in management or strategy at the investee company, such a manager who chooses to comply with the code will, among other issues, need to maintain a clear policy on the circumstances in which they will intervene or when they would be involved in collective engagement with the investee company. If they choose not to comply with the code, or certain elements of the code, then this needs to be explained.

This rule change is effective from today and so this needs to be considered immediately. A UK-regulated firm that manages investments for professional clients (and does not limit that activity to venture capital type situations only) must prepare a disclosure statement. Remember that although adherence to the code is not compulsory, a disclosure as to the regulated firm's approach to the code's principles is obligatory and so significant work may need to be completed to illustrate how compliance with the code is being achieved, while retaining the necessary degree of flexibility to enable the firm to amend its approach based upon the particular investment or client. From a practical perspective, firms could consider making an interim disclosure for the short-term which explains their general commitment to the code and provide a full detailed statement regarding their adherence to each of the code's principles, or their alternative approach, in the following weeks.

Author Biography:

Adam Palmer is a Director of ACA Compliance (Europe) Limited the compliance consultancy firm for wholesale financial services companies with a client focus of hedge fund managers, fund of funds managers and private equity fund managers and institutional brokers. Contact -