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«EN EN EUROPEAN COMMISSION Brussels, 5.4.2011 COM(2011) 164 final GREEN PAPER The EU corporate governance framework EN EN GREEN PAPER The EU corporate ...»

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(11) Do you agree that the board should approve and take responsibility for the company’s ‘risk appetite’ and report it meaningfully to shareholders? Should these disclosure arrangements also include relevant key societal risks?

(12) Do you agree that the board should ensure that the company’s risk management arrangements are effective and commensurate with the company’s risk profile?

E.g. resilience of the company's investments to climate change, financial or other implications from regulation on greenhouse gas emissions.

EU ‘critical infrastructure protection’ webpage:

http://europa.eu/legislation_summaries/justice_freedom_security/fight_against_terrorism/jl0013_en.htm From Commission interviews.

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Shareholders’ role in corporate governance was addressed in the Green Paper on corporate governance in financial institutions, published in June 2010.

The June 2010 Green Paper found that a lack of appropriate shareholder interest in holding financial institutions' management accountable contributed to poor management accountability and may have facilitated excessive risk taking in financial institutions. It found that, in many cases, shareholders deemed the expected profits from taking these risks worthwhile and so implicitly supported excessive risk taking, especially though high leverage.

The reason is that shareholders would fully benefit from the upside of such a strategy, while they participate in losses only until the value of shareholder equity reaches zero, after which further losses would be borne by the creditors (known as the "limited liability" of shareholders).

The behaviour of shareholders in financial institutions, in relation to excessive risk taking, may be a special case because their operations are complex and difficult to understand.

Nonetheless, the evidence gathered during the preparation of this Green Paper suggests that the findings of the 2010 Green Paper regarding the lack of shareholder engagement and the reasons for this are, to a large extent, also relevant to shareholder behaviour in listed companies with dispersed ownership. In companies with a dominant or controlling shareholder, it seems that the major challenge is to ensure that the (economic) interests of minority shareholders are adequately protected. In addition, minority shareholders who are willing to engage with companies may also be confronted with the difficulties set out below.

2.1. Lack of appropriate shareholder engagement

Shareholder engagement is generally understood as actively monitoring companies, engaging in a dialogue with the company’s board, and using shareholder rights, including voting and cooperation with other shareholders, if need be to improve the governance of the investee company in the interests of long-term value creation. Although engagement on the part of short-term investors may have a positive effect44, it is generally understood as an activity which improves long-term returns to shareholders45. Therefore, the Commission believes that it is primarily long-term investors46 who have an interest in engagement.

Some of the reasons for a lack of shareholder engagement were set out in the 2010 Green Paper and will not be repeated here. Some of these reasons, such as the cost of engagement, the difficulty of valuing the return on engagement and the uncertainty of the outcome of engagement, including free rider behaviour, seem to have an impact on most institutional investors47. In the 2010 Green Paper the Commission also asked whether institutional investors, including asset owners and managers, should be required to publish their voting policies and records. The vast majority of respondents supported such a rule. They thought public disclosure would improve investor awareness, optimise investment decisions by the For instance, engagement by typical short-term-oriented institutional investors, such as ‘activist’ hedge funds, may be beneficial, because it can act as a catalyst for a change in governance and raise awareness among other shareholders.

See the UK Stewardship Code.

Investors with long-term obligations towards their beneficiaries, such as pension funds, life insurance companies, state pension reserve funds and sovereign wealth funds.

For the purposes of this Green Paper, ‘institutional investor’ is understood in a broad sense, i.e. as any institution which professionally invests (also) on behalf of clients and beneficiaries.

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Major developments in capital markets in recent decades, including innovative products and technical change, mostly focused on the trading function of the capital markets and facilitated faster and more efficient trading. Innovations such as high-frequency and automated trading seem to have resulted in increased liquidity but also helped to shorten shareholding periods.

Over the past two decades, investment horizons have shortened considerably. Turnover on the major equity exchanges is now running at 150% per year of aggregate market capitalisation, which implies average holding period is eight months.

At the same time, intermediation of investments has increased, amplifying the importance of the agency relationship between long-term investors and their asset managers. It has been argued that the agency relationship actually contributes to short-termism on the market, which may also cause mispricing, herd behaviour, increased volatility and lack of ownership of listed companies. This issue is explained in Section 2.3.

Some investors have also complained of a ‘regulatory bias’ towards short-termism, which hinders long-term investors, in particular, from adopting longer-term investment strategies.

During the Commission’s preliminary consultations with stakeholders it was said that solvency and pension fund accounting rules, which were intended to promote greater transparency and more effective market valuation, have had unintended consequences.

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(13) Please point to any existing EU legal rules which, in your view, may contribute to inappropriate short-termism among investors and suggest how these rules could be changed to prevent such behaviour.

2.3. The agency relationship between institutional investors and asset managers The Commission recognises that not all investors need to engage with investee companies.

Investors are free to choose a short-term-oriented investment model without engagement.

However, the agency relationship between institutional investors (asset owners) and their managers contributes to capital markets’ increasing short-termism and to mispricing48. This issue is particularly relevant as regards the inactivity of long-term-oriented shareholders.

2.3.1. Short-termism and asset management contracts

It appears that the way asset managers’ performance is evaluated and the incentive structure of fees and commissions encourage asset managers to seek short-term benefits. There is evidence (confirmed in the Commission’s dialogue with institutional investors) that many asset managers are selected, evaluated and compensated based on short-term, relative Paul Woolley, ‘Why are financial markets so inefficient and exploitative — and a suggested remedy’, in The Future of Finance: The LSE Report, 2010.

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Many respondents to the June 2010 Green paper49 supported greater disclosure of the incentive structures for asset managers. The question is then whether additional measures to better align the interests of long-term institutional investors and asset managers are appropriate (for example developing a set of investment principles).

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(14) Are there measures to be taken, and if so, which ones, as regards the incentive structures for and performance evaluation of asset managers managing long-term institutional investors’ portfolios?

2.3.2. Lack of transparency about the performance of fiduciary duties More transparency about the performance of fiduciary duties by asset managers, including their investment strategies, the cost of portfolio turnover, whether the level of portfolio turnover is consistent with the agreed strategy, the cost and benefits of engagement, etc., could shed more light on whether or not asset managers’ activities are beneficial for long-term institutional investors and long-term value creation on their behalf.

Furthermore, information about the level of and scope of engagement with investee companies that the asset owner expects the asset manager to exercise, and reporting on engagement activities by the asset manager could be beneficial50.

More transparency on these issues would help institutional investors to better monitor their agents and thus have a greater influence on the investment process. As a consequence of such improved monitoring, long-term institutional investors might decide to renegotiate asset management contracts to introduce portfolio turnover caps and require their asset managers to be more active stewards of the investee companies51.

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(15) Should EU law promote more effective monitoring of asset managers by institutional investors with regard to strategies, costs, trading and the extent to which asset managers engage with the investee companies? If so, how?

Respondents in favour were mostly investors, asset managers, the (financial services) industry and business professionals.

See also paragraph 7.3.4 of the Public consultation on the Review of the Markets in Financial

Instruments Directive (Mifid):

http://ec.europa.eu/internal_market/consultations/docs/2010/mifid/consultation_paper_en.pdf On 31 January 2010, the ICGN Shareholder Responsibilities Committee has published a call for evidence with regard to model contract terms for agreements between asset owners and their fund managers: http://www.icgn.org/policy_committees/shareholder-responsibilities-committee/-/page/307/.

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Conflicts of interest in the financial sector seem to be one of the reasons for a lack of shareholder engagement. Conflicts of interest often arise where an institutional investor or asset manager, or its parent company, has a business interest in the investee company. An example of this can be found in financial groups where the asset management branch may not want to be seen to actively exercise its shareholder rights in a company to which its parent company provides services or in which it has a shareholding.

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(16) Should EU rules require a certain independence of the asset managers’ governing body, for example from its parent company, or are other (legislative) measures needed to enhance disclosure and management of conflicts of interest?

2.4.2. Obstacles to shareholder cooperation Individual investors, in particular those with diversified portfolios, may not always engage successfully. Shareholder cooperation could help them to be more effective.

Many respondents to the 2010 Green Paper proposed that existing EU law on acting in concert, which may hinder effective shareholder cooperation, should be amended. The Commission recognises that clearer and more uniform rules on acting in concert would indeed be beneficial in this respect. Other ideas have been advanced to facilitate shareholder cooperation: some suggest setting up shareholder cooperation fora, while others propose an EU proxy solicitation system where listed companies would be required to set up a specific function on their website enabling shareholders to post information on particular agenda items and seek proxies from other shareholders.

Some investors have mentioned that cross-border voting is still problematic and should be facilitated by EU legislation. The Shareholders' Rights Directive (2007/36/EC) improved this situation considerably. However late transposition of the directive by many Member States means the real impact for the individual end investor is only now becoming apparent.

Furthermore, there seems to be a problem in the actual transmission of relevant information between the issuer and the shareholder through the chain, particularly in cross-border situations. The Commission is aware of the difficulties and will look into this issue in relation to its work on harmonising securities law.

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Institutional investors with highly diversified equity portfolios face practical difficulties in assessing in detail how they should vote on items on the agenda of the general meetings of investee companies. So they make frequent use of the services of proxy advisors, such as voting advice, proxy voting and corporate governance ratings. In consequence, proxy advisors’ influence on voting is substantial. Moreover, it has been argued that institutional investors rely more heavily on voting advice for their investments in foreign companies than

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The influence of proxy advisors raises some concerns. During the preparation of this Green Paper, investors and investee companies shared their concerns that proxy advisors are not sufficiently transparent about the methods applied with regard to the preparation of the advice. More specifically, it is said that the analytical methodology fails to take into account firm-specific characteristics and/or characteristics of national legislation and best practice on corporate governance. Another concern is that proxy advisors are subject to conflicts of interest. When proxy advisors also act as corporate governance consultants to investee companies, this may give rise to conflicts of interest. Conflicts of interest also arise when a proxy advisor advises on shareholder resolutions, proposed by (one of) his clients. Finally, the lack of competition in the sector raises concerns, partly about the quality of the advice and whether it meets investors’ needs.

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(18) Should EU law require proxy advisors to be more transparent, e.g. about their analytical methods, conflicts of interest and their policy for managing them and/or whether they apply a code of conduct? If so, how can this best be achieved?

(19) Do you believe that other (legislative) measures are necessary, e.g. restrictions on the ability of proxy advisors to provide consulting services to investee companies?

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