June 2004

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Exercising ownership rights

Internationally, corporate governance is the system by which business corporations are directed and controlled, that is, the management and control routines that ensure that a company is run in a manner that protects and develops its financial assets.

Starting point: Protecting the shareholder’s long-term financial interests

The meaning of corporate governance often varies, depending on one’s relationship with the company. The company’s management and its board members will focus on how efficiently the company is run. Investment analysts and institutional investors will pay greater attention to board composition, procedures, accuracy of reporting and shareholder rights. Regulators will focus on corruption and fraud, while lawyers and auditors will focus on whether companies comply with laws and regulations. For many stakeholders, the purpose of corporate governance is to ensure that companies are run in a manner that safeguards and develops financial assets, and that relations with employees, customers, suppliers and the community are addressed satisfactorily. Det er imidlertid viktig at alle aktørene helt klart ser at det man ønsker å oppnå, er å sikre at selskaper blir styrt på en måte som beskytter og utvikler de finansielle verdiene, samt at relasjoner til ansatte, kunder, leverandører og miljøet rundt blir ivaretatt på en tilfredsstillende måte

The purpose of exercising ownership rights is to protect and develop the capital that the shareholder has invested in a company. Company’s decisions and motives may be influenced by the underlying time horizon, but an overarching objective is normally to maximise long-term financial results. In a well-functioning capital market, this is the same as maximising the price of the company’s shares; i.e. the market rewards “well-run” companies with higher share prices. The exercise of ownership rights and investment decisions aimed at increasing returns are therefore two sides of the same coin. Many of the recent scandals connected with poor corporate governance seem to reflect that company management has based decisions and market reporting on short-term perspectives. In the wake of these scandals, new and very detailed legislation has been passed in the US, whereas in Europe, the emphasis has been on formulating principles and recommendations for good corporate governance.

The key components of a well-functioning capital market are legislation (e.g. laws regulating companies, accounting practices and stock exchange operations, and laws to combat financial crime), supervisory bodies to monitor compliance with laws and regulations, and stock market supervision in connection with the trading of shares and other equity instruments. Capital markets function differently in different countries, and the extent to which the interests of shareholders are protected through legislation and supervision varies considerably. In general, the more efficiently a market functions, the less need there is for regulation to protect shareholders’ interests. However, the concentration of ownership, internal control systems and the degree of transparency in individual companies will influence how well shareholders’ interests are protected.

Possible conflicts of interest

The board and management do not always act in a manner that is in keeping with the long-term objective of protecting the company’s financial assets. Personal gain, power and politics may take priority over long-term value creation. Different shareholders may also have conflicting interests: for example, a shareholder with a controlling stake in a company can push through decisions that negatively impact smaller shareholders. A number of conflicts of interest may arise:

• Between shareholders and the board/management

  Ownership and control are separate in that the shareholders have delegated management and operating functions to the board and company management. If the interests of the board and executive management are not in line with those of the shareholders, the company may not always act in the interest of shareholders (the classic principal-agent problem).

  Although management’s incentives can largely be controlled through the remuneration structure employed, it is virtually impossible to devise an incentive structure that will address all potential conflicts of interest.

  Financial reporting shall provide accurate, complete and timely information. Share prices are affected by the information reported. A short-term inflation of the share price and other key financial figures may have a positive impact on management remuneration, but may mislead investors and shareholders to base decisions on incorrect information.

• Between shareholders and others with claims on the wealth created

  A company finances its activities in two ways: equity (principally shares and retained earnings) and borrowed capital (bonds and bank loans). If a company becomes insolvent, creditors will be protected by collateral in the company and will have priority over the owners of equity.

  In situations where a company is close to insolvency, conflicts of interest typically arise between these two groups of stakeholders. Creditors can recover up to the total amount they have lent, whereas shareholders will want to guarantee continued operation of the company because a potential rise in the company’s value will increase the probability that they will regain some of the capital invested.

  Employees, suppliers and customers are more or less protected by explicit contracts with the company. The degree of protection will depend on laws and regulations, which vary according to where the company is domiciled.

• Between different shareholders

  Shareholders are not a homogeneous group. They will vary over time and according to where the company is domiciled. Anglo-American markets (the US, Canada and the UK) are all characterised by a broad shareholder structure, whereas in the Japanese and continental European markets, there is extensive cross-ownership between industrial conglomerates and financial institutions.

  An important principle for protecting the interests of shareholders is equitable treatment. Shareholders with considerable stakes will have a greater incentive to monitor company management actively, and concentrated ownership will generally safeguard shareholder interests more effectively. At the same time, the interests of a major shareholder will often conflict with the interests of smaller shareholders because control brings with it opportunities for gain at the expense of smaller shareholders. Some Scandinavian companies have more than one share class. This form of differential treatment enables a shareholder to exercise control over a company without owning the majority of its share capital. Groups of companies with a pyramid structure, common in Italy, are another example where a shareholder may control a company without possessing the majority of the share capital.

• Between institutional investors and the owners of the assets they manage

  Institutional investors (pension funds, mutual funds and large fund managers) are management organisations that manage assets on behalf of someone else, either individuals with pension rights, individual investors or other individual mutual fund account holders. Those who make investment decisions in management institutions may be remunerated on the basis of relatively short-term performance targets, which may not always be consistent with protecting the long-term financial value of the assets they are managing.

• Between the company and society at large

  A company’s actions will also have social and environmental consequences. These consequences will not always be consistent with one another, at least not in the short term. For instance, a company may profit in the short term by shifting burdens onto its surroundings. An example of this is environmental pollution. However, in the longer term this may also become a problem for the company.

Means of exercising ownership rights Corporate actions

Shareholders have a number of rights tied to the shares they own in that they have a right or obligation to decide on proposals made by the company (corporate actions). Such proposals may involve choosing between (usually) two alternatives, such as whether to receive a dividend from the company in the form of shares or in cash, offers from the company to buy back part of its share capital at a given price, an acquisition offer from another company, etc. These corporate actions have a value for the shareholder, and it is important for the shareholders to use the opportunity to safeguard their financial interests in the company.

Voting

Some corporate actions are the result of decisions taken at the company’s general meetings, such as company strategy, board composition, anti takeover devices and mergers, the company’s capital structure or incentives for board members, management and employees. In many cases, voting at general meetings is the only opportunity shareholders have to influence decisions that directly affect the company’s financial position. The company management usually prepares the agenda for the general meeting. Company legislation and the company’s articles of association regulate which matters shall be decided by shareholders through voting at the general meeting.

Shareholders also have the right to add their own items of business to the general meeting agenda. A shareholder motion may often involve a vote of no confidence in the management. Conflicts of this nature with major investors are almost always resolved before the voting stage is reached. Shareholders who focus on particular matters that do not directly involve a lack of confidence in the board or management may also request that these matters be added to the agenda as separate items of business.

Contact with the company’s management and board

Shareholders can put forward their views and try to influence the company through contact with the company’s board and management. Discussion topics will largely depend on who the investor is. Institutional investors will typically focus on matters of principle, such as the independence of board members, remuneration structures, transparency in reporting, but questions of a more strategic nature may also be discussed. Active ownership is costly and resource-intensive. Management’s willingness to engage in a dialogue will generally depend on the topics touched upon, the shareholder’s insights and expertise and last, but not least, the size of the shareholder’s stake. Cooperation among investors on individual matters may give them greater influence. Major private shareholders will typically focus on strategic issues and perhaps also matters of a more operational nature.

Collaboration among shareholders

An important international development is that large institutional shareholders have strengthened their collaboration in order to exert more influence on companies and regulatory bodies. Most large pension funds have laid down guidelines for the exercise of ownership rights based on shared fundamental values.

Investors can collaborate on individual matters vis-à-vis companies, either through a dialogue with the company’s management and board or by collaborating in connection with voting at general meetings. In addition, investors can try to influence government bodies and stock exchanges to develop regulations that best protect the interests of shareholders.

The best-known informal international networks of institutional investors are the International Corporate Governance Network (ICGN) and the Global International Governance Network (GIGN). ICGN has recently issued a document on principles for the exercise of ownership rights and voting. There are also a number of networks of investors and other interest groups that focus on specific topics vis-à-vis both individual companies and regulatory agencies.

National and international regulations and conventions

To varying degrees, different countries’ financial markets are subject to legislation and regulations intended to ensure that companies act in a manner that best protects the shareholders’ interests. Thus, the challenges of exercising ownership rights will largely depend on the market and will be influenced by various traditions related to culture, the way businesses operate and how the financial markets function.

One important reason why the challenges connected with corporate governance and the exercise of ownership rights differ in Anglo-American and continental European countries, is that ownership spread differs. In European countries, large shareholders are protected at the expense of smaller ones, and this makes cross-border ownership difficult. A key challenge is how to prevent considerable assets from falling to large shareholders at the expense of the smaller shareholders. In the Anglo-American countries, the main challenge is that the management is too strong and has too much freedom when there are many small shareholders. Primary focus has been on regulating the board and its role in monitoring the company’s management.

Large stakes held by banks and insurance companies and cross-ownership between companies characterise the shareholder structure of Japanese companies. In recent years, however, individual shareholdings have increased, as a consequence of both the increasing openness of the Japanese economy and the fact that companies are focusing more on profits in order to compete with foreign companies. These changes make the exercise of ownership rights and the interests of shareholders more relevant, also in Japan.

In emerging markets, corruption and financial market inefficiency may be a considerable problem. Missing or poor information and faulty legislation make it difficult for shareholders to monitor whether companies are operating in a manner that looks after their interests. Expropriation (such as when dividends due to foreign shareholders are held back or not paid at all) is a problem in a number of these markets.

In the wake of the numerous corporate scandals in recent years, the exercise of ownership rights has become an important topic in many countries. Parallel with demands for greater involvement of shareholders, stock markets and regulators have tightened regulations and monitoring of companies’ governance, control and accounting systems and routines. New regulations have been added and new legislation proposed. Recurring themes include greater transparency in relation to shareholders, more robust risk and control systems, combating corruption and insider trading, information about executive pay and more focus on ethics.

It is important to point out, however, that since the end of the 1980s, more than 40 countries have implemented new laws and regulations for the exercise of ownership rights, many of them quite radical. Propelling this development has been globalisation, with a growing number of multinational corporations, greater transparency in previously closed markets and cross-border investment.

In June 2002, a new law was passed in the US. The main purpose was to promote the accurate and independent auditing of listed companies and ensure the separation of investment banks and brokerage businesses to avoid conflicts of interest. The law also addresses fraud and corruption.

In November 2003, the US Securities and Exchange Commission (SEC) approved new corporate governance standards for the New York Stock Exchange (NYSE) and NASDAQ. The SEC has also proposed that ¾ of the members of a board of directors be independent. In addition, the SEC now requires mutual fund managers to publish voting results, which is not common in other countries.

In Europe, laws and regulations for corporate governance and the exercise of ownership rights are increasingly converging. Most countries have already established, or are in the process of establishing, their own recommendations for corporate governance. In May 2003, the European Commission adopted a supplementary Corporate Governance Action Plan for amendments to laws and regulations to be made by 2010. The plan is not a mandate for member states, but a proposal based on member states formulating their own national principles and recommendations. Companies that do not follow the recommendations will have to state their reasons.

International conventions and guidelines

The World Bank, the OECD and the UN have played a key role in formulating international corporate governance standards.

In 1999, the OECD adopted principles of good corporate governance that address the equitable treatment of shareholders and that promote disclosure and transparency. The principles also cover corruption and fraud. The OECD has also formulated guidelines for multinational corporations that cover such areas as labour rights, human rights, competition, and consumer interests.

The World Bank is focusing its efforts on shareholder rights, the equitable treatment of shareholders, the rights of other stakeholders, transparency in reporting and the role of the board of directors. The World Bank is using the OECD principles as a frame of reference in evaluating a country’s status in these areas.

In 1999, the UN introduced the Global Compact, a collection of nine principles that encourage companies to promote and respect international human rights. These principles also cover workers’ rights and encourage companies to undertake initiatives to promote greater environmental responsibility and to promote sustainable international trade, which can help globalisation to have a positive impact on the majority of the world’s population.

Institutional investors and the exercise of ownership rights

Historically, institutional investors have not been particularly active in the exercise of ownership rights. This has changed in recent years, especially in the US and the UK. The numerous corporate scandals of recent years have led to greater attention to the exercise of ownership rights based on shared fundamental values.

An important reason for large international investors to pay more attention to the exercise of ownership rights is that their very size implies that selling out of large companies is not a realistic option. Managers of large funds must invest in many companies to diversify their risk. In addition, institutional investors have a long time horizon for their investments. When there is a limited possibility of advancing one’s views by selling out, influencing the company is a more suitable option.

Many institutional investors manage funds for more than one client. These clients may have differing guidelines and requirements for how the institutional investor is to exercise ownership rights on their behalf. For example, some clients do not want voting rights to be used or ownership rights to be exercised actively, whereas others have explicit guidelines for how ownership rights are to be exercised. This means that even if the institutional investor manages a large overall capital base, it is not certain that he can wield the same influence that that capital base would imply.

On the other hand, however, in a survey of investors conducted by McKinsey (1), about 60 per cent of active managers reported that evaluations connected with governance and control of companies may result in a decision not to invest in certain companies or to reduce holdings in those companies, because they consider corporate governance to be an activity where the costs far exceed the benefits. Some claim that it would take a long time before any real changes occurred in the company and that other investment managers (competitors) would take advantage of the improvement (the “free rider” problem).

Most institutional investors have guidelines for the exercise of ownership rights. The main purpose of such guidelines is to protect long-term financial interests. Many have published their guidelines by posting them on the institution’s website. In this way, an institution can clearly define the basis of its participation to companies as well as other investors who may be potential partners on specific issues. The investors also have detailed guidelines for the exercise of voting rights. Many investors also publish outlines of the specific actions and measures taken vis-à-vis companies and regulators.

International investors and voting

An international investor desiring to vote at the general meeting of a foreign company encounters several obstacles.

To vote at a general meeting, the shareholder must either attend in person or arrange for a local agent to attend (proxy voting (2)).

Information about when a company meeting is to take place, the items on the agenda and information on the business to be decided must be obtained from the company. Disclosure requirements and the format of the information may vary widely between markets. Interpreting and not least the translation of documentation may result in insufficient or erroneous information.

In many European companies, the shares are blocked in connection with voting, i.e. the shares cannot be sold from the time a shareholder has voted (one or two weeks before the meeting) until the meeting is held. As a result, many investors choose not to vote, in order to have the option of selling their shares.

Many markets require that when proxies are used, the shareholder must document that a local agent can vote on their behalf. This documentation must be renewed on a regular basis.

Once votes are cast, companies are not required to confirm that they have received the votes, nor do they have to publicly disclose the outcome of the vote.

Common points in the guidelines for the exercise of ownership rights among institutional investors

For institutional investors, the focus of exercising ownership rights will depend on the markets in which they invest. However, institutional investor guidelines seem to have the following points in common:

• The objects of the company and its business strategy: The company must have a clearly defined business strategy, and any substantial change must be approved by the company’s shareholders.
• Governing structure: There must be formal requirements for the governing structure, and the company must have systems for independent measurement and control to ensure that the company is managed in accordance with the interests of the shareholders. The board’s most important role is to represent and protect the interests of shareholders. The board must oversee the day-to-day management and operations and ensure that the business is organised properly. The work of the board and the individual members must be evaluated regularly.
• Board composition: The board must have a high degree of independence from the company’s management and be subject to election at regular intervals. At elections, shareholders must have adequate information on the candidates in order to form an opinion.
• Division of the roles of chairman of the board and managing director: A guiding principle for many investors is that the functions of board chairman and managing director should be separated, because they represent two essentially different roles that require different expertise and focus. This is an important point in the US in particular, since the same person traditionally has both roles.
• Compensation for the board and management: Remuneration should be based on an incentive programme that depends on the company’s value added over time and should largely depend on the efforts of management. Any option or share programme must not dilute the ownership stakes of existing shareholders. Agreements on compensation that involve the allotment of shares or options must be approved by the general meeting. The total remuneration to each board member and senior executive must be publicly disclosed.
• Capital structure: As a general rule, ordinary shares should carry one vote each. New shares may be issued as long as the issuance does not serve to block acquisition or dilute the ownership stakes of existing shareholders. New share classes that give the board wider authorisations, for example, an increase in share capital, voting rights, dividend conversion and veto rights should not be endorsed.
• Anti-takeover devices in the event of an attempted takeover: Formal obstacles to acquisition may not be established, since defence mechanisms of this type are not in the interests of the shareholders.
• Information and reporting: The company must provide accurate, relevant and timely information about its economic and financial position and about all other matters of importance that may affect the value of the company.
• Independent auditing: The use of an auditor for assignments other than auditing (consulting assignments) may compromise the auditor’s independence. Guidelines for remuneration in connection with assignments of this kind are an important instrument for promoting independence.
• Socially responsible investments: Investments that focus on social responsibility, the environment and ethics have historically been limited to funds or investors with specific views or convictions in respect of questions of this type. Many investors have increased their involvement in this area by either directly or through a service provider engaging in an active dialogue with companies on various topics, such as human rights and the environment.

The exercise of ownership rights in the Petroleum Fund

The Petroleum Fund acts as a financial investor and is not among the major shareholders in any of the approximately 2900 companies in which the Fund has invested. The numerous scandals in recent years related to weak corporate management and shareholder control have illustrated the importance of ensuring better protection of shareholder interests.

The framework for Norges Bank’s exercise of ownership rights in the Petroleum Fund is found in Section 11 of the regulations, which states: “Norges Bank shall not exercise ownership rights linked to shares unless this is necessary to safeguard the financial interests of the fund.” The substantial inflow of capital to the Petroleum Fund in recent years has increased the Fund’s ownership interests in equity markets (see Chart 10 in the first section of the Annual Report for 2003). Thus, the possibility of looking after its ownership interests has also increased. Against this background, Norges Bank has increased its efforts to exercise ownership rights. A year ago, the Ministry of Finance was briefed about these plans in a separate submission.

Exercise of ownership rights so far

The Petroleum Fund is managed both by Norges Bank and by a number of external managers. Norges Bank has chosen a decentralised model in which, pursuant to the agreement, the external managers are to safeguard the Petroleum Fund’s financial interests through an obligation to adopt a position on voluntary corporate actions and the right to vote on behalf of the capital they manage. The managers are under no obligation to contact Norges Bank prior to voting.

Until 2003, Norges Bank did not exercise its voting rights for the portfolio that is managed internally. Since the extent of internal management has increased, however, Norges Bank began a year ago to exercise its right to vote on behalf of the capital that is managed internally. Separate guidelines have been established for the exercise of ownership rights within the framework of the regulation. The guidelines have been published on Norges Bank’s website.

The Executive Board of Norges Bank has delegated the voting to Norges Bank Investment Management. Since the purpose is to safeguard the financial interests of the Fund, there is substantial synergy between this activity and the financial analyses and assessments on which management of the Fund is based. Therefore, the individual portfolio managers are responsible for taking the decisions on voting within the stipulated framework.

Since internal equity management began in 1999, Norges Bank has continuously exercised ownership rights related to corporate actions. As a manager of equities, Norges Bank has to decide on a number of proposals from companies in connection with corporate actions. In 2003, Norges Bank had to adopt a position on more than 1300 corporate actions relating to internally managed capital. Similarly, the external managers had to decide on corporate actions in connection with the capital they manage.

In 2003, Norges Bank entered into a contract with Institutional Shareholder Services (ISS), the world’s leading provider of proxy voting and corporate governance services. ISS analyses proxies and issues informed research and objective vote recommendations for more than 10,000 U.S. and 12,000 non-U.S. shareholder meetings each year. Actual voting is delegated to the internal portfolio managers in Norges Bank Investment Management and is performed using a web-based voting platform. Reporting takes place over the same platform. In order to exercise voting rights with limited personnel input from their own organisations, large international investors use similar consulting services.

The Annual Report for the Government Petroleum Fund (see page 24) contains an overview of voting in 2003. So far, Norges Bank Investment Management has focused on the 150 largest companies in the portfolio. These constitute about 50 per cent of the market value of the equity portfolio. Underlying this decision is a desire to target resources where they might be expected to yield the greatest return. The plan is to gradually increase the number of companies that are followed up with a view to exercising voting rights.

Ethical guidelines

In its recommendation (submitted to the Ministry of Finance on 25 June 2003), the public committee that was established to propose ethical guidelines for the Petroleum Fund attached importance to obligations to future generations of Norwegians. This implies that the Fund shall be managed with a view to achieving the highest possible return. On the other hand, the committee also emphasised the obligation to respect basic human rights, which implies that the Fund’s investments shall not contribute to gross violations of such rights.

The committee recommended the exercise of ownership rights as one of the instruments for helping companies to follow ethical standards. In the proposed guidelines for the exercise of ownership rights, the committee gave priority to the Fund’s primary objective, which is to attain a high return in the long term. In addition, the committee argued that there is no essential conflict between this objective and the principles in the documents on which the exercise of ownership rights is to be based. However, the committee also states: “In cases where the connection between ethics and long-term return is either unclear or negative, the exercise of ownership rights will not be an appropriate instrument for promoting ethical considerations”.

The committee stressed the exercise of voting rights and dialogues with company management as relevant activities in the exercise of ownership rights. The committee further stated that Norges Bank will have a responsibility to inform companies of the general expectations inherent in the guidelines and to ensure that companies have established internal procedures to verify that these expectations are being followed up. However, Norges Bank cannot guarantee that all companies at all times will fulfil the ethical requirements or expectations specified in future guidelines from the Ministry of Finance.

1 McKinsey Investor Opinion Survey 2002

2 Electronic voting has been introduced in Australia, France, Germany, Japan and the UK.