TABLE OF CONTENT

1. Introduction.. 6

2. Procedural Issues and Consultation of Interested Parties. 6

2.1. External expertise and consultation of interested parties. 6

2.2. Procedural issues. 8

3. Policy context.. 9

3.1. Nature and size of the equity market. 9

3.2. Regulatory framework.. 13

3.2.1. Existing framework. 13

3.2.2. Ongoing developments. 14

4. Problem definition.. 15

4.1. Background.. 15

4.2. Insufficient engagement of institutional investors and asset managers. 17

4.3. Insufficient link between pay and performance of directors. 25

4.4. Lack of shareholder oversight on related party transactions. 29

4.5. Doubts on the reliability of the advice of proxy advisors. 32

4.6. Obstacles to the exercise of shareholder rights. 34

4.6.1. Identification of shareholders. 34

4.6.2. Cross-border transmission of information by intermediaries, including exercise of shareholder rights. 35

4.6.3. Price discrimination by intermediaries for cross-border transmission of information, including exercise of shareholder rights 36

4.7. Insufficient quality of corporate governance information.. 37

4.8. Which stakeholders are affected and how?. 38

5. Baseline scenario, the EU's right to act and justification.. 42

5.1. Baseline scenario.. 42

6. EU’s right to act, subsidiarity and proportionality, respect for fundamental rights. 44

7. Objectives. 45

8. Policy Options, Impact Analysis and choice of preferred option.. 46

8.1. Increase the level of engagement of institutional investors and asset managers. 46

8.1.1. Description. 46

8.1.2. Analysis of impacts and choice of preferred option. 47

8.2. Create a better link between pay and performance. 51

8.2.1. Description. 51

8.2.1. Analysis of impacts and choice of preferred option. 52

8.3. Transparency and oversight on related party transactions. 57

8.3.1. Description. 57

8.3.2. Analysis of impacts and choice of preferred option. 58

8.4. Transparency of proxy advisors. 62

8.4.1. Description. 62

8.4.2. Analysis of impacts and choice of preferred option. 62

8.5. Shareholder identification, transmission of information and instructions by intermediaries. 65

8.5.1. Description. 65

8.5.2. Analysis of impacts and choice of preferred option. 65

8.6. Improving the quality of corporate governance reporting.. 73

8.6.1. Analysis of impacts and choice of preferred option. 74

9. Overall impacts of the package.. 76

10. Monitoring and Evaluation.. 78

Annex I. Glossary.. 80

Annex II. List of main EU measures in the area of corporate governance.. 82

Annex III. Overview of responses to consultations specifically devoted to corporate governance 83

Annex IV. Summary of ad hoc discussion with stakeholders. 88

Annex V. Main findings of the external Study on Monitoring and Enforcement Practices in Corporate Governance in the Member States. 93

Annex VI. Overview of situation in MemberStates. 94

Annex VII. Additional information on policy context, problems and drivers. 104

Annex IX. Impact on competitiveness of EU companies. 115

Annex XI. List of references. 118

Executive Summary Sheet

Impact assessment on Proposal for a Directive on encouraging shareholder engagement amending Directive 2007/36/EC on the exercise of certain rights of shareholders in listed companies and proposal for a Recommendation on enhancing the corporate governance framework

A. Need for action

Why? What is the problem being addressed?

This impact assessment analyses certain problems in the area of corporate governance of European listed companies. Five main problems have been identified: 1) Insufficient shareholder engagement 2) Insufficient link between pay and performance of directors 3) Lack of shareholder oversight on related party transactions 4) Doubts on the reliability of the advice of proxy advisors, 5) Difficult and costly exercise of rights flowing from shares, 6) Insufficient quality of corporate governance information. These problems lead to suboptimal corporate governance and a risk of suboptimal and/or excessively short-term focused managerial decisions which result in lost potential for better financial performance of listed companies and lost potential for cross-border investment.

What is this initiative expected to achieve?

This initiative should improve the governance and (financial) performance of EU listed companies, contribute to enhancing the long-term financing of companies through equity markets and improve the conditions for cross-border equity investments. This objective should be reached by increasing the level of engagement of institutional investors and asset managers with their investee companies; by creating a better link between pay and performance of company directors; by enhancing the transparency and shareholder oversight on related party transactions; ensuring the reliability and quality of advice of proxy advisors, by facilitating the exercise of existing rights flowing from shares by shareholders and by an improvement of the quality of information on corporate governance provided by companies.

What is the value added of action at the EU level?

Considering the growing importance of cross-border equity investments (some 44% of the total market capitalisation of EU listed companies is held by foreign investors), there is need for targeted EU intervention to address the problems described above. Only a limited number of Member States has undertaken action or is considering doing so, and these actions cannot bring effective solutions to these problems. Action from Member States alone is likely to result in different sets of rules creating an uneven level playing field, which may undermine or create new obstacles to the good functioning of the internal market.

B. Solutions

What legislative and non-legislative policy options have been considered? Is there a preferred choice or not? Why?

A variety of options has been considered to solve the problems, including a no policy change scenario, soft law/recommendation and different degrees of legislative actions. The following preferred options have been identified: 1) Shareholder engagement – transparency of institutional investors and asset managers’ as regards their voting and engagement policy and investment strategies, together with certain aspects of asset management mandates and their implementation; 2) Remuneration – requiring disclosure of the remuneration policy and individual remunerations and submitting it to shareholder vote; 3) Related party transactions – requiring additional transparency and an independent opinion on more important transactions and submitting the most substantial transactions to shareholder approval. 4) Proxy advisors – requiring disclosure on conflicts of interests and methodology, 5) Facilitation of the exercise of existing rights of shareholders – obligation for intermediaries keeping securities accounts to facilitate shareholder identification and the exercise of rights flowing from shares 6) Corporate governance reporting – recommendation providing guidance on the quality of reports

Who supports which option?

1) Institutional investors and asset managers’ – support by shareholders, institutional investors and companies. 2) Remuneration –supported by shareholders, institutional investors, asset managers and proxy advisors, but also companies, provided that the concrete measures remain flexible; 3) Related party transactions – support by shareholders especially minority shareholders and asset managers; 4) Proxy advisors – support by shareholders, institutional investors, asset managers and companies; 5) Facilitation of the exercise of existing rights of shareholders – support by shareholders and companies; 6) Corporate governance reporting – shareholders, asset managers, institutional investors and companies.

C. Impacts of the preferred option

What are the benefits of the preferred option (if any, otherwise main ones)?

The benefits of the proposed package of options are difficult to quantify. The package will increase the level of transparency in the equity investment chain, which will contribute to a realignment of interests among actors and a better focus on the long-term interests of final beneficiaries in investment strategies. Moreover, it should give shareholders more effective tools to oversee directors. Proxy advisors’ services could gain on reliability. The proposed package is expected to have positive economic effects, as it contributes to an improvement of corporate governance of listed companies and their long-term sustainability. This in turn could have indirect positive social impacts on employees and consumer, i.e. in this case, ultimate beneficiaries of assets institutional investment. No specific environmental benefits are expected.

What are the costs of the preferred option (if any, otherwise main ones)?

The exact costs of the proposed package of options are difficult to quantify. Most options imply improved transparency and disclosure which will create limited additional costs. These costs would be incurred by different stakeholders – listed companies, institutional investors and asset managers, proxy advisors and intermediaries keeping securities accounts. The main costs for companies would be related to the disclosure of the remuneration policy and the remuneration report as well as of the most significant related party transactions and its external evaluation. Only negligible cost would be linked to a shareholder vote on these issues, mostly to take place during general meetings. Companies will also have to pay if they want to benefit from the services of shareholder identification. Some limited costs could also be linked to the improved corporate governance reporting. Costs for institutional investors and asset managers would be linked to the publication of the voting and engagement policies and voting records. Shareholders may see a rise in the costs for an improved service of facilitation of shareholder rights. Some limited costs for proxy advisors would be linked to the publication of their policy regarding conflicts of interests and the methodology for the preparation of advice. There should be no negative social or environmental impacts.

How will businesses, SMEs and micro-enterprises be affected?

The proposed measures would only apply to listed companies. This means that only listed SMEs would be affected and micro-enterprises will not be covered. In principle, there should be no general derogatory regime for the listed SMEs as the proposed rules should be flexible so as to allow companies to adapt them to their situation, but derogations from certain specific requirements could be envisaged. The costs and burden should be limited. There should be a positive impact on the sustainability of listed companies in general, including SMEs.

Will there be significant impacts on national budgets and administrations?

There should be no significant impact on national budgets and administration. The latter would be required to transpose the proposed measures into national law.

Will there be other significant impacts?

Disclosure of individual remuneration might have an impact on fundamental rights (right to protection of personal data of the directors concerned). The package might have an impact on the competitiveness of EU companies, as it might slightly increase their costs and burden, while also enhancing their long-term sustainability.

D. Follow up

When will the policy be reviewed?

The Commission will monitor the implementation of the proposed measures and evaluate their effectiveness. It will consider the need for amendments on the basis of the assessment done five years after the expiry of the implementation period.

1. Introduction

The past years have highlighted certain corporate governance shortcomings in European listed companies. These shortcomings relate to different actors in the corporate governance of companies: companies’ and their boards, shareholders (institutional investors and asset managers), intermediaries and proxy advisors. Companies and their boards have paid remuneration to their directors that was insufficiently linked to performance, concluded related party transactions of which it was not clear whether it was in the best interest of the company, including from a long-term perspective, and have provided corporate governance information that lacked quality. Institutional investors and asset managers have, generally speaking, not sufficiently engaged with companies they invest in, while the advice from proxy advisors to institutional investors and asset managers gave rise to doubts on its quality and reliability, thereby compromising the voting and engagement of shareholders. Finally, intermediaries have, especially in a cross-border context, not always enabled shareholders to exercise their rights in an effective and efficient manner.

On the basis of consultations and research conducted, the Commission adopted on 12 December 2012 an Action Plan on European company law and corporate governance[1] outlining the initiatives to be taken in the coming years in order to modernise the current framework. The main objectives in the area of corporate governance are enhancing shareholder engagement and improving transparency between companies and investors.

This impact assessment considers possible ways to achieve the objectives set out in the Action Plan.

2. Procedural Issues and Consultation of Interested Parties

2.1. External expertise and consultation of interested parties

In its reflection on the functioning of the European corporate governance framework the Commission has benefited from the advice of the European Corporate Governance Forum.[2] In addition, an external study on the monitoring and enforcement of corporate governance rules in Member States was performed in 2009.[3]

A study performed by an external contractor on directors’ duties and liabilities evaluates current rules on related party transactions.[4]

Following the financial crisis, the Commission undertook a thorough review of the current corporate governance framework and held two public consultations in line with Commission standards. First, the 2010 Green Paper on corporate governance in financial institutions and remuneration policies[5] discussed the role of shareholders and in particular the lack of shareholder engagement. A majority of respondents was in favour of mandatory disclosure of voting policies and records by institutional investors.[6]

As regards listed companies in general, the 2011 Green Paper on the EU corporate governance framework contained a chapter on the role of shareholders.[7] Respondents[8] were in favour of increasing transparency as regards executive remuneration, of granting shareholders a say on pay and of improving the informative quality of corporate governance reports. They also supported measures regarding monitoring of asset managers by asset owners, more transparency from proxy advisors and reinforcing current rules on related party transactions.[9] Although there was an overrepresentation of replies from the UK[10], the results of the consultations would have been essentially the same if there were no replies from the UK.[11] The low response of public authorities[12] can be explained by the fact that only a low level of shares of European listed companies are held by public authorities in general, namely 4%.[13]

As regards the issue of shareholder identification, transmission of information and facilitation of shareholder rights two public consultations containing questions on these issues were held in line with Commission standards. The responses and two extensive summaries are published on the internet[14]. The first consultation in 2009 aimed to collect information on the need to improve the EU-wide framework for securities holding and disposition and how future EU legislation could address the issues identified[15]. The Commission got 99 responses. The majority supported the legislative action based on their own experience of the difficulties (but support was heterogeneous and dependent on the respondents' field of business or nationality). All factual information provided is fully integrated in this report, especially with regard to the need for evidence to justify EU action. A second consultation[16] was conducted in 2011 on principles for harmonising EU securities law.

The Commission sent a questionnaire to the Company Law Experts Group[17], which is composed of Member States representatives, on the Member State framework on the issues analysed in this Impact assessment. Moreover, it conducted a number of technical discussions with experts from groups of stakeholders (in particular pension funds, asset managers, issuer companies, retail investors, employees, proxy advisors, stock exchanges and regulators).[18] In addition, corporate governance issues were debated during an academic conference on the Action Plan on Company Law and Corporate Governance organised by the European Corporate Governance Institute (ECGI).[19] Finally, some corporate governance problems have been discussed in the Green Paper on the long-term financing of the European economy[20] which has initiated a broad debate about how to foster the supply of long-term financing and how to improve and diversify the system of financial intermediation for long-term investment in Europe.

2.2. Procedural issues

The impact assessment was prepared by the Directorate-General for Internal Market and Services.[21] An Inter-Service Steering Group (ISSG) was set up to follow progress and feed in views from other services of the Commission, including Directorates-General for Enterprise and Industry, Employment, Social Affairs and Inclusion, Taxation and Customs Union, Economic and Financial Affairs, Justice, Competition, Environment, Legal Service and Secretariat General and the European Data Protection Supervisor. The steering group met three times, in February, April and May 2013.

This report was submitted to the Impact Assessment Board, which discussed it on 17 July 2013 and issued an opinion. The comments received from the Impact Assessment Board resulted in the following changes in the revised impact assessment that was finalised on 10 October 2013.

First, to the problem definition additional data were added to identify more clearly the size of the problems. Moreover, the links between the different problems identified in the problem definition were clarified, as were the links with the existing legislative framework and the on-going work of the Commission. With regard to the analysis of impacts, evidence was added to demonstrate the impact of the options. Where possible this evidence is quantitative, but stakeholder opinions were also reported in more details, in order to give insight into the opinions of the different stakeholder groups. Moreover, the potential impact in terms of administrative burden was strengthened. Finally, the effectiveness of the package of measures to solve the problems in the problem description was further analysed.

It should be noted that the part of the impact assessment on shareholder identification, transmission of information and facilitation of the exercise of shareholder rights was initially dealt with in a separate context and was integrated only in the final impact assessment report. For that part, the impact assessment procedures were also followed and the text was cleared by the Impact Assessment Board in April 2013.

3. Policy context

3.1. Nature and size of the equity market

The European rules on corporate governance apply only to ‘listed’ companies, which are companies that issue securities admitted to trading on a regulated market situated or operating in a Member State.[22] It is considered that companies that do not raise money on capital markets should not be subject to the same requirements as listed companies, as there is no need to ensure protection of external investors.[23]

There are currently some 10400 listed companies in the EU The total market capitalisation of EU listed companies is a bit more than 8 trillion euro.[24] The size of the market in Member States is very different. The UK stock market is the largest with a market capitalisation of some 2,4 trillion euro after which come the French stock market with a market cap of some 1,4 trillion euro, the German stock market with 1,2 trillion euro and the Spanish stock market some 780 billion. These four Member States cover 70% of total market capitalisation in the EU and 66% of all listed companies.

The ownership structures in the EU are diverse – while in the UK, Ireland and the Netherlands dispersed ownership of the capital is predominant, in continental Europe the concentrated ownership model is the leading scheme, although there is a clear tendency towards the dominance of dispersed ownership in some Member States.[25] For example, only 25% of large cap companies have large block holders in Germany.[26] In the dispersed ownership system, there is a “separation of ownership and control” with share ownership being dispersed among many institutional and retail shareholders and no shareholders typically holding significant blocks.[27] In the concentrated ownership system, a shareholder, a family group, or a small number of shareholders hold a significant block of shares and often have the power to appoint representatives on the companies’ boards, thus obtaining a certain level of control over its management.[28]

Listed companies in Europe have a limited number of retail shareholders: only 11% of the market value of shares was owned by individuals in 2011. The largest category of shareholders is foreign investors with 44% of the market value. 23% of the value of shares is owned by institutional investors such as pension funds, insurers and other financial intermediary companies, mutual funds and collective investment companies; 16% by non-financial companies (limited liability companies, foundations etc.), 4% by general government and 3% by banks.[29]

The share of foreign investors in total market capitalisation in the different Member States is depicted is shown in the below figure. For the four Member States with the largest market capitalisation and the largest number of listed companies foreign investors hold between 40 and 50% of the market capitalisation of shares. This percentage of foreign ownership over has gone up from 10% in 1975 to 44% in 2011.[30]

A large part of the foreign investors are foreign institutional investors and asset managers. Over the last decades the ownership structure of listed companies in most OECD countries has moved from direct ownership to intermediary ownership.[31] According to the OECD, in 2010 institutional investors and asset managers held nearly half of the shares of listed companies in the world, which would mean that this percentage is considerably higher for shares in free float.[32] Institutional investors’ share in European companies’ capital has increased substantially, which makes them a major force on the stock market; although their importance varies across markets (for example it attains only 6% in Romania but as much as 50% in Germany and Ireland).[33] In total, EU pension funds and insurers have invested more than 4 trillion Euros in equities,[34] which equals some 57% of the total market capitalisation of EU listed companies.

As regards the term ‘institutional investors’, for the purposes of this impact assessment, it will be used to designate asset owners. Asset owners hold assets on behalf of ultimate investors who bear the economic risks of the investment. The most typical of these are pension funds, insurance companies, banks and sovereign wealth funds. According to InsuranceEurope total assets under management of insurers are some 8.5 trillion Euro[35], of which almost 33% is invested in shares.[36] PensionsEurope stated that it represents some 3.5 trillion in assets.[37] Many asset owners manage assets in-house, but they increasingly rely on the expertise of external asset managers. An example is that in 2009 approximately 93% of Dutch pension assets were invested externally with one or more asset managers, while this percentage was less than 50% in 2001.[38] The Kay report notes that decisions on voting and acquisition and disposal of shares are most often exercised by asset managers.[39]

Asset managers manage the assets of asset owners and households. They can do so either through investment funds (the most important being Undertakings for Collective Investment in Transferable Securities (UCITS)[40], or through discretionary mandates. Most assets managed by asset managers are done so by means of discretionary mandates[41], namely 53%.[42] European asset managers had in 2012 some 14 trillion euro of assets under management. 29% of these are invested in equity. 75% of the assets under management came from institutional investors. From this 75%, 42% came from insurers and 33% of pension funds, which suggest that a very large majority of assets of pension funds and more than half of those of insurance companies are managed by asset managers. Most of these assets are managed in a limited number of Member States, namely in the UK (36%), France (20%) and Germany (10%). For assets managed under discretionary mandate the UK’s market share is 47%, for France 19%, the Netherland and Italy 6% and 4% for Germany.[43]

Proxy advisors are important advisors to institutional investors and asset managers, since they provide voting advice to shareholders, which is particularly important for institutional investors and asset managers that hold shares in hundreds or thousands of companies.[44]

A simplified structure of the equity (share) investment chain is described in the schema below. It is important to note that there is no uniform EU definition of a shareholder, so Member States laws define who is entitled to exercise shareholder rights. In case of the use of asset managers generally the asset owners define the general framework for the investment strategy and asset allocation and the terms of the mandate also define who will be entitled to vote as a shareholder.[45] In practice it is increasingly the asset manager and almost never final beneficiaries, such as future pensioners, insurance policy holders or bank account holders who decide on how the vote should be cast.

Figure 1: schema of the equity investment chain

Shares are held and transferred through a complex, sophisticated and international network of intermediaries. Intermediaries hold securities in an account for someone else, e.g. when an issuer decides to issue securities to the public (investors) it usually hires an intermediary, e.g. investment banking firm. The newly issued securities are then deposited in a Central Securities Depository (CSD) or an International Central Security Depository (ICSD). Banks can also hold and trade securities on behalf of others as intermediaries or on their own books as an investor. Intermediaries, though, do more than just hold the securities for investors. Generally, intermediaries act on investors’ instructions to carry out transactions. They channel the rights flowing from the share to the investor (e.g. dividends) and, in cases they are instructed to do so, they exercise the rights attached to the share on behalf of the investor (e.g. voting).

3.2. Regulatory framework

3.2.1. Existing framework

The EU corporate governance framework is a combination of legislative rules and soft law, in particular corporate governance codes.[46] While corporate governance codes are adopted at national level, Directive 2006/46/EC promotes their application by requiring that listed companies refer in their corporate governance statement to a code and that they report on their application of that code on a ‘comply or explain’ basis.[47] This approach gives companies an important degree of flexibility in their corporate governance, since these national codes are not only adapted to the different national corporate governance models, but in addition companies can deviate from their provisions.

However, some key corporate governance aspects have been harmonised at EU level through directives. Most relevant in this respect is Directive 2007/36/EC on the exercise of certain rights of shareholders in listed companies, which contains rules on information provided to shareholders before the general meeting and on the participation and voting in such meetings. According to the Directive a shareholder is a legal or natural person that is recognised as a shareholder under the law of the Member State where the listed company has its registered office (Article 2 and 1(2) of the Directive).Other important acts are the Transparency Directive[48] which requires issuers of listed securities to provide to investors financial information and information on major holdings, and the Takeover Bids Directive[49] that provides for common rules for takeover bids, in particular as regards the protection of minority shareholders in cases when control of a company changes hands. Moreover, Directive 2012/30/EU on the capital of companies addresses shareholders’ situation in case of capital increase or reduction. Finally, the Commission has adopted a number of recommendations[50], which deal in particular with the role of non-executive directors and the composition of board committees as well as the remuneration of directors.[51]

Stricter corporate governance rules apply to financial institutions. In particular, the new Capital Requirements Directive and Regulation (CRD IV package)[52], which will replace the existing rules as of 1st January 2014, constitutes a major step towards creating a sounder and safer financial system. In the area of corporate governance, the new provisions concern in particular the composition of boards, their functioning and their role in risk oversight and strategy in order to improve the effectiveness of risk oversight by boards. The status and the independence of the risk management function are also enhanced. Finally, the package strengthens the existing rules on remuneration, by setting a ratio between the variable and the fixed component of remuneration.

A number of specific EU acts regulate institutional investors and asset managers. In particular, as regards the activity of asset owners, Solvency I[53] and II rules are applicable to insurance companies, including life insurance. Solvency II is currently under revision to improve the conditions for insurers to invest in the long-term.[54] Directive 2003/41/EC on the activities and supervision of institutions for occupational retirement provision (IORP)[55] regulates pension funds. As regards asset managers, the UCITS Directive[56], currently under revision[57] and Directive 2011/61/EU on Alternative Investment Fund Managers (AIFM)[58] contain rules applicable to management through certain funds, while the Markets in Financial Instruments Directive (MIFID) (Directive 2004/39/EC)[59], currently also under revision[60], is applicable to management under discretionary mandates. More details on the provisions relevant for corporate governance can be found in annex XII.

There is no international harmonisation in the field of corporate governance, however the OECD Principles on Corporate Governance[61] of 2004 are considered as a major benchmark in this field.

As regards rules applicable to intermediaries keeping securities accounts for investors and transmit information between companies and investors, the MIFID Directive referred to above is relevant. Central Securities depositories are currently regulated by national law but will be subject to EU regulation in the future (see 2012 Proposal for a Regulation on Central Securities Depositories, currently under negotiation with the Council and Parliament[62])

3.2.2. Ongoing developments

Among the current initiatives, the revision of the Transparency Directive[63] has impact on shareholders, as it modifies the regime of notification of major holdings of voting rights. The recent Commission proposal on disclosure of non-financial and diversity information by certain large companies and groups[64] aims at increasing EU companies’ transparency and performance on environmental and social matters, but also on risk management and diversity in company boards, and, therefore, to contribute to sustainable growth and employment. The Commission also proposed a regulation on European Long-term Investment Funds (ELTIF). The ELTIF allow investors to put money into companies and projects that need long-term capital. It is aimed at investment fund managers who want to offer long-term investment opportunities to institutional and private investors across Europe, e.g. in infrastructure projects. However, this proposal targets long-term investments in non-listed companies.[65]

The so called "Omnibus II" Directive was adopted at the end of 2013 and would amend the solvency regime for insurance companies. The Omnibus Directive includes a new so called "long-term guarantees package" that will support overcoming regulatory distortions to long-term business and investments triggered by short-term volatility in financial markets. This should improve the conditions for insurance companies to invest in the long-term. The new regime would apply from January 2016.

Furthermore, the Commission has recently presented a follow-up to the Green paper on long-term financing of the European economy, which includes a number of measures to improve the regulatory framework and incentives for long-term investments. It proposes a transparency measure to incentivise institutional investors and asset managers to take better account of environmental, sustainability and governance information (ESG) in their investment decisions. This measure would be complementary to this proposal as it would also aim at incentivising institutional investors and asset managers to take better account of the medium to long-term interests of their end-beneficiaries and of the companies they invest in when defining and executing investment strategies and awarding asset management mandates. It would thus also contribute to more responsible share-ownership.

4. Problem definition

4.1. Background

This impact assessment analyses a number of problems in the area of corporate governance. Corporate governance is traditionally defined as a set of relationships between a company’s management, its board, shareholders and other stakeholders.[66] One of the key issues in corporate governance is the separation between ownership and control and the resulting principal-agent relationship between shareholders and directors. Classic principal-agent theory demonstrates that the fact that shareholders (“principals”) delegate management of the company to the directors (“agents”) leads to information asymmetries[67] and leaves room for these directors to act sometimes more in their own self-interest than in the interest of the shareholders. This could lead to suboptimal corporate governance and suboptimal financial performance of companies.

Good corporate governance is in the first place a responsibility of listed companies themselves, but there is, like in any governance system, a need for checks and balances. If not, directors ‘mark their own homework’, which often leads to non-objective assessments of their own performance. Shareholders, in particular institutional investors and asset managers, but also other stakeholders like employees, play a key role in providing, from their different perspectives, checks and balances. The precise checks and balances differ however from Member State to Member State.

Changes in the equity investment chain, in particular the increased role of intermediaries and increased cross-border shareholdings, have exacerbated the existing principal-agent problem and have contributed to a lack of shareholder engagement with investee companies and have made the identification of the shareholder, the transmission of information to shareholders and the exercise of shareholder rights more difficult and costly. These changes in the equity investment chain make it necessary to look beyond the mere relation between shareholders and the listed company.

Shareholder engagement is generally understood as the active monitoring of companies by shareholders, engaging in a constructive dialogue with the company’s board, and using shareholder rights, including voting, to improve the governance and financial performance of the company. Whether the corporate governance of listed companies’ functions well depends, amongst others, on the engagement of shareholders and use of their rights.

In this regard the question is whether institutional investors and asset managers are interested at all to engage on corporate governance of listed companies: Stakeholders indicate that asset managers are, on purpose or not, often not incentivised by the asset owner to engage on companies’ corporate governance and performance. Moreover, such engagement is more difficult with large number of (cross-border) holdings, since it presupposes more detailed knowledge on (all) these companies and their corporate governance, but also on the national corporate governance framework applicable to them. However, Member States’ themselves have given shareholders important tools, for instance on remuneration and on related party transactions, and shareholders themselves ask for more tools.[68] Finally, there is a growing group of investors that opt for an engagement investment strategy. Academic studies underpin these decisions, since they demonstrate that such strategies lead to increased performance of both investments and of investee companies.

The extent to which institutional investors and asset managers will decide to engage more with investee companies depends, amongst others, on the costs and difficulties attached to it. Consultations and extensive informal meetings have shown the Commission in which areas stakeholders see particular problems and where they cannot, due to a lack of comprehensive, clear and comparable information or proportionate tools, engage. Secondly, whether institutional investors and asset managers will engage depends on whether they have incentives to do so. For this reason this impact assessment looks at two distinct, but closely related problems: on the one hand the lack of good and reliable information on EU companies’ corporate governance and proportionate tools to engage and on the other hand the lack of engagement of institutional investors and asset managers.

The problems, their drivers and their consequences are depicted graphically in the following problem tree and are described more in detail below. It should be noted that the analysis of the problems described below is constrained by the scarcity of statistical data and by the confidential nature of some of the evidence available to the Commission.

Figure 2: problem tree

Drivers Problems Consequences

4.2. Insufficient engagement of institutional investors and asset managers

The financial crisis has revealed that shareholder control did not function properly in the financial sector. Rather than ensuring good decision-taking by companies, shareholders, especially institutional investors, have often been either absent or did not take action against or even supported excessive, short-term risk taking.[69] Listed companies in general do not have markedly different shareholders than financial institutions and there are signs of a lack of sufficient long-term oriented shareholder engagement here too.

A recent OECD report considered that ‘the current level of “monitoring” of investee companies by institutional investors is sub-optimal’ and that a great deal can be done by private agents and policy makers to improve the corporate governance outcomes of institutional investors behaviour”.[70] A UK government commissioned study, the Kay review, concluded that “short-termism” of investors is a problem in UK equity markets, and that the principal cause of this is the misalignment of interests between asset owners and asset managers. According to this study equity markets currently encourage exit (the sale of shares) over voice (the exchange of views with the company) as a means of engagement, replacing the concerned investor with the anonymous trader. Moreover, the study pointed also to increased foreign shareholding, which would have reduced the incentives for engagement and the level of control enjoyed by each shareholder[71]: shareholders hold, generally speaking, smaller (minority) holdings in listed companies and it is, for cross-border investors, more difficult and costly to engage with these companies, while the relative benefits of engagement are shared with more investors. The data on the concentration of asset management in a limited number of Member States show the cross-border relevance of this problem.

The problem analysed in this chapter is the lack of engagement of institutional investors and asset managers. This lack of engagement leads to suboptimal corporate governance of listed companies, a risk of short term focused strategic decisions and lost potential for better financial performance of listed companies. Studies demonstrate that shareholder engagement on corporate governance issues is not only creating value for the shareholders[72], but contributes also to a significant improvement of the governance, operating performance, profitability and efficiency of the investee companies.[73]

Looking at the current level of shareholder engagement, the most common form of shareholder engagement is voting in general meetings.[74] With regard to this means of engagement studies show that average turnout is around 60% in Europe. However, the turnout of minority shareholders (typically (foreign) institutional investors and asset managers) is a mere 37%, while average dissent regarding resolutions is around 2-3%.[75] Where minority shareholders do vote, they typically rely heavily on proxy advisors, especially in case of cross-border holdings. In the USA[76] average turnout is some 81% and in Japan some 74%. The relatively low turnout at general meetings in Europe can be explained by the relatively high level of foreign share ownership.[77] Furthermore, the low level of dissent in general meetings of shareholders may also be an indication of a suboptimal level of shareholder engagement.

After voting in general meetings the most commonly mentioned forms of shareholder engagement are private engagement and collaboration with other shareholders. Among the most responsible investors surveyed in 2012, only 39% claim to engage in private with companies. There is however no extensive data available on these means of engagement by shareholders, which can be explained by the fact that such engagement is not necessarily recorded.[78] The below figure gives an overview of investors’ use of engagement strategies.[79]

The proportion of assets managed under engagement and voting strategies is still relatively small compared to other investment strategies in Europe.[80] According to the European Sustainable Investment Forum (Eurosif), engagement and voting strategies[81] now represent less than 2 trillion Euros[82] in Europe, compared to 14 trillion Euros of assets under management by asset managers. In the last two years this number increased however with 8,1%. It is to be noted that almost three quarters of this 2 trillion euro concern assets under management in the UK and the Netherlands.[83] Recently, the Norwegian sovereign wealth fund, that, according to the Economist, on average holds 2,5% of every European listed company, was reported as having decided to take a more active role in managing its portfolio of companies and push them to improve their corporate governance.[84]

Figure 5: Growth of engagement and voting strategies in Europe[85]

In a recent Dutch survey, Dutch listed companies were asked how they perceive engagement of shareholders. Only 30% of Dutch institutional investors are perceived to have a dialogue with the company.[86]

There is however a rising interest in responsible investing, which typically aims at maximising financial return by integrating a wider range of long-term risk and return factors, such as environmental, social and governance matters into the valuations of companies (‘Integration strategies’). Using data from 9 European countries, Eurosif finds that almost 70% of all engagement assets (2 trillion) are subject to such integration.[87]

The UN Principles for Responsible Investing gave further impetus to the development of responsible investing when adopted in 2006. Responsible investors "seek a sustained competitive advantage and outperformance, partly by evaluating a company's overall management ability to adapt to dynamic business climate and create enduring value"[88]. They are interested in the long-term value of companies and are said to exhibit active ownership which entails shareholder engagement.[89] Many UN PRI signatories are European asset owners and asset managers.[90] The reporting system for signatories does at this moment however not allow seeing how much shareholder engagement takes place by signatories.[91]

The most recent survey (2013) of the UK association of pension funds[92] reports that 82% of respondent pension funds agreed that ESG factors can have a material impact on their fund’s investments in the long-term. The survey also reports about an increasing interest of being more active owners: 56% of respondents agreed that institutional investors had played an active enough role in their investee companies, compared to 50% in 2012 and 54% agreed that engagement had added (or prevented loss of) value to the fund (53% in 2011 and 2012). The survey demonstrates that respondents see more evidence of engagement activities influencing changes on corporate governance issues (such as board composition, remuneration, corporate strategy and performance) than on social and environmental issues[93].

At EU level the recently adopted Commission proposal on disclosure of non-financial and diversity information by certain large companies and groups will increase the transparency on environmental, social and some governance matters (diversity and risk management) and will therefore give shareholders important material to engage with listed companies. However, it does not give further tools to shareholders, nor does it aim to make shareholders more engaged.

The main driver for an insufficient level of shareholder engagement appears to be the incentives within the equity investment chain which do not sufficiently encourage increasing the value of the investments through shareholder engagement and creating real economic value stemming from increased efficiency and competitiveness of the investee companies. Asset owners make more and more use of asset managers. Delegation of asset management to asset managers creates an agency problem.[94] Asset managers have access to more and better information than the asset owners that make use of them and the interests and objectives of agents may differ from those of their principals. Although they have different portfolio horizons, the largest asset owners, such as pension funds and insurers are inherently long-term oriented as their liabilities are long-term.[95] However, for the selection and evaluation of asset managers they often rely on benchmarks, such as market indexes. Underperformance relative to the benchmark index may lead to the termination of the asset management mandate[96], while the performance is often evaluated and discussed on a quarterly basis.[97] Furthermore, performance fees for individual fund managers are, to varying degrees, linked to performance versus a standard industry benchmark.[98]

As a result, although asset owners have an important interest in the long-term absolute performance of their assets, many asset managers’ main concern has become their short term performance relative to a benchmark, while they have an incentive to outperform each other on the shorter-term. Moreover, the fact that the performance horizon on which the asset manager is often evaluated is short, is a disincentive to engage, because shareholder engagement usually bears fruit only over a longer period of time[99], while the benefits of engagement will be shared with other shareholders.[100] Short-term incentives turn focus and resources away from making investments based on the fundamentals (strategy, performance and governance) and longer term perspectives, from evaluating the real value of companies and increasing their value through shareholder engagement.[101]

One indicator of the short performance horizon of shareholders is the average holding period of shares which now stands at some 8 months (see figure 2).

Figure 2. Average Holding Period - Selected Exchanges [102]

In view of the existence of high frequency trading this figure may however not be the best indicator for short-termism of traditional longer-term asset owners and managers.[103] Looking at data about deviations from expected levels of portfolio turnover (i.e. the frequency of buying and selling stocks) of traditional longer term asset managers provides a better picture about the magnitude of short-termism of traditional asset managers. When portfolio turnover rates exceed their expected range by a notable margin, this could be an indicator of a lack of conviction in investment decisions and momentum-following behaviour.

A recent study[104] examined the differences between planned and actual turnover rates.[105] Of 822 fund strategies between 2006 and 2009[106], nearly two thirds considerably exceeded their expected turnover levels. Average annual turnover was 72% with some 20% of funds being above 100% which implies a full turnover of the entire portfolio in one year or less. Less than 10% of asset managers have less than 33% of turnover, the equivalent of a three year investment horizon. 65% exceeded their expected turnover by approximately 30% on average.[107] The study concludes that short-termism exists and managers do not necessarily behave according to their stated approach.[108]

At EU level there are currently a limited number of provisions that ensure a certain transparency on the engagement and voting policies and their application in practice of asset owners and managers.[109] As regards transparency of asset managers, for assets managed through discretionary mandates (53% of the market), regulated by MIFID[110], and where there is potentially the biggest scope for improvement for giving better incentives for shareholder engagement[111], there is only a limited rule on disclosure about investment strategies and costs to investors. For assets managed in funds (47% of the market) both the UCITS and the AIFM Directive require that these funds set up a strategy for the exercise of voting rights, but they are only required to make a short description of these strategies available to investors on their request.[112] There are some rules on the disclosure of the costs of asset management too.[113] In sum, these provisions do not ensure a sufficient transparency of the large majority of asset managers towards institutional investors, nor of institutional investors towards final beneficiaries, which contribute to informed decision taking. In practice, a survey under 189 institutional investors and asset managers showed that 35% has an engagement policy which is disclosed by only 24%, whereas only 16% disclose the outcome of such policies.[114]

As regards potential solutions to these problems the 2010 and 2011 Green papers as well as the Green paper on long-term financing of the European economy asked a number of questions. In the context of the 2010 Green Paper disclosure of institutional investors’ voting practices and policies received strong support from stakeholders. A clear majority of Member States responding supported EU action on this issue[115], while some Member States were against EU action.[116] Stakeholders considered that such disclosure would raise awareness of investors, optimise investment decision of ultimate investors and facilitate engagement between shareholders and listed companies.

In the context of the 2011 Green Paper the majority of shareholders and institutional investors supported a more effective monitoring of asset managers by institutional investors, particularly with regard to strategies, costs, trading, and the extent to which asset managers engage with the investee companies. However, they expressed themselves mostly in favour of transparency and the diffusion of best practices (but not binding regulation). Companies were also slightly in favour. Asset managers strongly opposed such measures claiming that these aspects are already covered by contractual agreement (mandates) and therefore there is no further need of intervention. Finally, the majority of Member States supported non-binding rule[117] while those opposing an action mostly justified their view affirming that mandates should regulate this aspect.[118]

In the context of the Green paper on the long-term financing of the European economy asset owners, asset managers and companies seemed to agree that the interaction between asset owners and asset managers is key to the promotion of shareholder engagement and that current practice reinforce their short-term focus. EuropeanIssuers[119] considers that capital markets do not reward fundamental analysis sufficiently; instead, it is easier to make money from trading activities which do not require analysis of underlying economic realities. Thus market incentives reward traders rather than investors.[120] EFAMA[121] agrees that there are a number of practices that are currently common in the relation asset owner/manager interaction that reinforce a focus on the short term. These practices include the review of performance on a quarterly basis and the reporting of performance drivers on a quarterly basis. The almost continuous focus on short term movements by asset owners and their advisers lead asset managers to hold companies to account over more short term periods. PensionsEurope[122] considers that "no incentives should be given within the equity investment chain to drive short-term behaviour" and that pension funds should monitor their manager’s investment performance ideally with reference to long-term absolute performance and (…) when assessing investment performance, pension funds should seek to discuss performance with reference to the previously agreed upon investment strategy and not feel pressured to respond to what may be short-term market fluctuations.[123] Insurance Europe is of the view that "long-term commitment in investment strategies is key in delivering performance and beneficial to investors and the economy as a whole" and that long-term performance measures and high watermarks should be used by asset owners when defining asset manager mandates.[124]

The consultation on long-term financing of the European economy asked stakeholders what kind of incentives could help promote better long-term shareholder engagement. It also asked how the mandates and incentives given to asset managers can be developed to support long-term investment strategies and relationships and whether there is a need to revisit the definition of fiduciary duty in the context of long-term financing.[125] Stakeholders strongly supported encouraging better alignment of interests in the equity investment chain, and many stakeholders are in favour of more transparency about portfolio turnover and costs and how asset owners and managers take the long-term interests of their beneficiaries into account and many of them support longer-horizon performance review.

It should be noted however that long-term investors are also interested in short-term profits, also to meet their liquidity needs. Furthermore, selling shares and consequent price declines may also exert a certain pressure on managers for self-discipline to regain credibility. The problem, from a corporate governance point of view, arises when there is a significant shift towards interest primarily in short term value, as demonstrated by portfolio turnover data of long-term investors, crowding out longer-term relationships and engagement. Furthermore, long-term asset owners recognize the importance of and the opportunity in long-term investing.[126] The growing importance of ESG investors shows that more and more asset owners and managers look at a broader range of longer-term risk factors, including governance, when assessing the overall risk of their portfolio and engage with investee companies to improve their governance and performance. More shareholder engagement is likely to bring benefits for the shareholders and investee companies alike (see under chapter 4.7 and 9).

4.3. Insufficient link between pay and performance of directors

Remuneration of directors has been a constant theme for policy makers, academics[127] and the media for a number of years. Shareholders may agree with a high pay to directors when they perform very well and when they get value for their investment. However, such pay to directors who are perceived as having underperformed has attracted much criticism from shareholders and, also, from civil society which cannot, especially in times of financial crisis and unemployment, understand the justification for such pay.

This problem occurs because of the principal-agent relation between shareholders and directors which leaves room for directors to act more in their own self-interest than in the interest of the shareholders. Directors’ remuneration plays a key role in aligning the interests of directors and shareholders and ensuring that the directors act in the best interest of the company. Where shareholders do not oversee directors’ pay, there is an important risk that directors will apply a strategy which rewards them personally, but that may not contribute to the long-term value of the company. Therefore, lack of oversight may lead to unjustified transfers of value from companies and their shareholders to directors.

The existence of this problem is shown by recent data which demonstrate that there is often an insufficient link between pay and performance. In France[128] and Austria[129], where shareholders do not have a say on directors’ pay, the average remuneration of directors in the years 2006 to 2012 increased with respectively 94% and 27%, although the average share prices of listed companies in these countries decreased with respectively 34% and 46%. Moreover, recent scandals show the award of generous pay packages with no obvious link to performance. For instance, the WPP advertising company paid £13 million to the CEO in 2011 and £17 million in 2012 although shareholders considered this package not proportionate to performance.[130] Before that, at the French company Vivendi, a € 21 million severance package gave rise to public criticism.[131] More recently, the golden handshake of the CEO of Nokia caused furore.[132]

Consultations and academic studies[133] show that regulation of directors’ pay, and in particular its relationship with performance[134], is a key concern for shareholders and that significant improvements could be made. Stakeholders argue that it is often difficult to identify the important information amongst all kind of detailed information in the current directors’ remuneration reports. The complexity of directors’ pay makes it hard to disentangle what executives are actually earning and for shareholders to judge whether this is appropriate.[135] Moreover, the quality of disclosure is insufficient since information on the fixed and variable component of the remuneration policy, and in particular the link between pay and performance, continues to be one of the least published pieces of information by companies.[136] This makes it time consuming, if not impossible, and costly to assess remuneration and to compare between companies, especially across borders. Moreover, academic studies and factual evidence suggest that the proportion of long-term incentives[137] in the variable pay of directors is quite low[138], and that the performance criteria adopted in relation to variable pay (and the time horizon)[139] are often insufficiently aligned with the longer term interests of the company.

However, at the EU level, there are currently no binding rules on director’s remuneration in listed companies, except for the requirement for companies to report, in the annual accounts, on the amount of emoluments paid to members of the administrative, managerial and supervisory bodies.[140] The Commission adopted three Recommendations on directors’ remuneration.[141] The main recommendations are disclosure of remuneration policy, the individual remuneration of executive and non-executive directors, and a shareholder vote on the remuneration. However, Commission reports[142] and further analysis by the Commission show that the application of these main recommendations by Member States is not satisfactory, since only 6 Member States have fully implemented these main principles. As a result, in Europe, shareholders currently often face difficulties to be properly informed and to exercise control over directors’ pay.

By comparison, in the United States, federal legislation requires a high level of disclosure of executive remuneration, with comprehensive disclosure in 12 tables amongst which the ratio CEO salary/mean salary information.[143] In addition listed companies must submit remuneration policies of some of their directors (including the CEO and CFO) to an advisory vote by the general meeting at least every three years. In Switzerland, a recent referendum introduced a shareholder vote on the global amount of remuneration and banned the golden parachutes and other termination payments.[144]

Indeed, in many Member States, shareholders do not have sufficient information on directors’ remuneration since the information disclosed by companies is not comprehensive, clear nor comparable. 15 Member States[145] require disclosure of the remuneration policy and only 11 Member States[146] require disclosure of individual directors’ pay. Four Member States have published templates that companies should use to disclose directors’ remuneration.[147] According to available data from 19 Member States, only around a third of the listed companies disclose how remuneration is dependent on performance.[148] Even in the other Member States, the situation is problematic: in the Netherlands for instance, under the relevant corporate governance code provisions, compliance with the obligation to describe the relation between pay and performance is one of the least applied provisions with an application of 64%; moreover, there was almost never an explication for non-compliance.[149] The Dutch corporate governance monitoring committee in this respect also noted in 2013 that in general pay structures and remuneration policy are not simple and transparent and that the committee has not been able to bring any improvements in this area.[150]

Furthermore, in many Member States, shareholders often do not have sufficient tools to express their opinion on directors’ remuneration which in their view is not appropriate or not justified by performance. Indeed, only 13 Member States give shareholders a say on pay through either a vote on directors’ remuneration policy and/or report.[151] 10 Member States have introduced a binding shareholder vote[152] and three an advisory one.[153] Moreover, the Member States approaches are very diverse. For example, in France, there is currently no legislative requirement to have a vote on the remuneration policy, report or on individual remuneration, but shareholders have a right to vote on certain specific issues linked to remuneration.[154]

The experience of Member States shows the positive impact of “say on pay” on creating a link between directors’ remuneration and companies’ performance.[155] In Italy[156] and Spain[157], before the introduction of an advisory say on pay in 2011, the average share price in the years 2006 to 2011 went down with respectively 130% and 40%, while the average remuneration of directors of listed companies increased by respectively 29% and 26%. However, since the law has been adopted in 2011, the average share price of listed companies has respectively increased by 10% and decreased by 5%, but the remuneration of directors has also increased by 1% and declined by 10%. There may be several reasons for this development, but this correlation has also been demonstrated by academic studies that showed in 2004 that the implementation of the regulation introducing an advisory say on pay in the United Kingdom has resulted in reduction of CEO remuneration in case of poor performance.[158]

Such link between pay and performance is even stronger in Member States where shareholders have been granted a binding say on pay. In Sweden[159] and Belgium[160], before the adoption of a binding say on pay in respectively 2010 and 2011, the average share price from 2006 to 2009 and from 2006 to 2011 went down respectively with 17% and 45%, while average pay of directors of listed companies increased respectively with 18% and 95%. However, since the laws were adopted in respectively 2010 and 2011, the share price has respectively increased by 16% and 18% but the remuneration of directors has also increased with 18% and decreased (as a correction) by 10%. Academic studies also show that the introduction of a binding say on pay in the Netherlands in 2007 has resulted in a closer link between shareholder value and remuneration and in greater levels of engagement between companies and shareholders.[161]

4.4. Lack of shareholder oversight on related party transactions

One of the most commonly heard complaints about corporate behaviour concerns related party transactions (RPTs): transactions between a company and its management, directors, controlling entities or shareholders.[162] An example of such a transaction is a contract between a company and its chief executive officer under which the former sells a 100% subsidiary to the latter. Generally, the approach is not to forbid such transactions, since they can be productive and create value, but to regulate them.[163]

The EU legislative framework requires companies to include in their annual accounts a note on material transactions entered into with related parties that are not concluded under normal market conditions, stating the amount and the nature of the transaction and other necessary information.[164] The Transparency Directive 2004/109/EC[165] and the implementing Directive 2007/14/EC[166] contain some further transparency obligations for listed companies. This framework provides some harmonisation of the rules on RPTs, focused on ex post disclosure.[167] There are however no EU rules that provide for public disclosure at the time of the conclusion of the RPT, nor for involvement of shareholders.

Member States have regulated RPTs in very different manners. Some Member States have solely taken over the EU Accounting provisions in this area[168], others have created more detailed transparency rules with specific thresholds or specific procedural obligations[169], while many Member States give the (supervisory) board a specific role whereas directors with whom a transaction would be concluded are sometimes excluded from voting.[170] In addition, in some Member States independent advisors have been given a role[171] and in a number of Member States shareholders have to approve RPTs.[172] Finally, a number of Member States also forbid certain specific RPTs.[173] However, even where Member States follow in essence the same approach, the details of their rules are very often quite different[174], which makes it difficult, time consuming and costly for foreign investors to try to influence decisions on important RPTs.

EU companies report a high level of RPTs. In Spain 78% of listed companies reported a significant RPT[175] in the last three years; in Ireland 47%; in Austria 22%; in France 15%; in Poland 14%; in Italy 8%; in Germany 7%; in the UK 5,5% and in the Netherlands 0%.[176] The three Member States with the highest percentage of reported RPT do not foresee an obligatory fairness opinion for the largest RPT, nor a shareholder vote. 35 % out of a sample of 54 listed companies in Germany reported significant RPTs in the year 2011.[177] In a sample of 85 companies listed on the Paris stock exchange 80 % reported RPTs. In total, the latter reported 1.186 RPTs over a period of three years. 30 % of these companies reported ten or more transactions. 371 of the RPTs were considered likely to lead to unjustified transfer of value to related parties.[178] It should be noted that under EU law companies are only obliged to report those transactions that are not concluded on market terms, and therefore could entail unjustified transfers of value to the related party.[179]

In the OECD’s Peer review on RPTs a number of Member State systems were assessed. For Belgium, the OECD report considered that a more direct role for shareholders in approving key transactions might be considered as well as greater formalisation of the law.[180] In France the existing rules are actively debated and the streamlining of the rules and an improvement of the information to the market are advocated.[181] Moreover, the French Autorité du Marché Financier has recommended the nomination of an independent expert and a shareholder vote in case of a significant RPTs.[182] Finally, studies show that RPTs can have a negative impact on the value of the company[183], since they transfer value from the company and its minority shareholder to those who control the company, the directors and/or the companies affiliated with them.[184]

The high level of reporting of RPTs concluded on non-market terms does not mean that all reported transactions entail unjustified transfers of value. However, it does mean, certainly in view of the opinions of stakeholders, that there is an EU corporate governance issue as far as minority shareholder protection is concerned. A significant majority of the shareholders and asset managers and a small majority of institutional investors that responded to the 2011 Green Paper are in favour of EU action to ensure more procedural protection against RPTs. All of them support an increase in transparency. Most responding shareholders and asset managers, supported by the views of several institutional investors, explicitly call for shareholders' approval of significant related party transaction, excluding the interested party. On the other hand a majority of responding companies oppose EU actions on related party transactions, since national measures would in their view be sufficient. A majority of Member States that replied to this question advocate however an EU wide disclosure regime that would make related party transactions more transparent[185], while a large minority of Member States[186] supports an EU action giving shareholders a vote. The existing rules do not provide minority shareholders, amongst which asset owners and managers with large portfolios of foreign shares with the necessary information and proportionate and cost-effective tools to assess and defend themselves against RPTs.

4.5. Doubts on the reliability of the advice of proxy advisors

Many institutional investors and asset managers use the services of proxy advisors who provide recommendations how to vote in general meetings of listed companies. The number of (cross-border) holdings by many institutional investors and asset managers and the complexity of the issues to be considered make the use of proxy advisors in many cases inevitable. One important benefit for investors is that these specialised advisors help reduce costs of the analysis of the information on companies.

Proxy advisors are not subject to any regulation at EU level. Non-binding rules exist only in few Member States. For example, the French Autorité du Marché Financier (AMF) recommendation on proxy advisors promotes transparency in the establishment and execution of voting policies by proxy advisors and recommends establishing appropriate rules on the management of conflicts of interest.[187] In the UK, the Financial Reporting Council’s Stewardship Code also applies to proxy advisors.[188]

Although in many cases institutional investors and asset managers vote on the basis of various sources of data, proxy advisors have an important influence on voting behaviour of investors[189], which makes them, to some extent, a standard setter in the area of corporate governance.[190] In particular, investors with highly diversified portfolios and many foreign holdings of shares rely more on proxy recommendations.[191] During a recent consultation by ESMA[192], “most respondents acknowledged there is a high correlation between voting outcomes and proxy advices”. The impact of proxy advisory firms’ recommendations is reinforced by the characteristics of this sector[193], in which there is currently limited competition: only two proxy advisors are able to meet the (European) needs of internationally operating investors.[194] In the Netherlands the Dutch Corporate governance code Monitoring Committee noted that of the Dutch and foreign institutional investors that took part in a survey 56% indicated that they made use of proxy advisors. Of the asset managers 100% made use of them. 83% of these two groups made use of one the two biggest proxy advisors, ISS and Glass Lewis. They only very slightly deviate from the advice given.[195] According to the underlying study the influence of the proxy advice is, on a scale of 10, 5.5 for Dutch companies, but 7,8 for foreign listed companies. Institutional investors and asset managers estimate that the degree of checking the advice is 8.3 for Dutch companies and only 3.4 for foreign listed companies.[196] According to an OECD study the German government stated that 80% of the foreign institutional investors follow the advice of proxy advisors.[197] In other words, especially for cross-border shareholdings the influence of proxy advisors is very significant, to a large extent uncontrolled by their users and issuers and, in view of the existing lack of transparency, uncontrollable. The 2012 survey conducted by the Dutch Monitoring Committee of the Corporate Governance Code states that investors in companies with widespread shareholdings in particular, especially foreign investors tend to be guided by proxy advisors on the basis of "foreign best practices" that cannot be considered in all cases as being generally accepted best practices.

Proxy advisors’ relations with issuers may also give rise to concerns. The different services provided to issuers, such as governance consultancy, may affect the independence of the proxy advisor and their ability to provide an objective and reliable advice. As proxy advisors are subject to conflicts of interests[198], appropriate procedures for the prevention, detection and treatment of such conflicts are necessary.

In view of the important role of the recommendations of proxy advisors these should be accurate and reliable. However, stakeholders noted shortcomings concerning the quality of advice, such as for example advice not taking account of certain key features of the national corporate governance framework, as well as situations of conflict of interests, for example when proxy advisors also provide services to companies.[199] A majority of respondents to the 2011 Green Paper considered that the level of transparency of proxy advisors was not sufficient, which made the evaluation of accuracy and reliability of the work of proxy advisors difficult. There was a strong support from shareholders, institutional investors and asset managers to increase the transparency of the methodology used and for addressing the conflict of interest problem. Companies also called for regulation of the sector, mainly justifying it by pointing to the risk that could arise from the influence proxy advisors currently have. Furthermore, all proxy advisors that answered to the consultation affirm to be in favour of more transparency and the diffusion of a code of conduct.[200] Finally, the majority of the Member States that expressed their views were in favour of increasing the transparency of the methodology used and addressing the conflict of interest,[201] while only few saw it was unnecessary.[202]

Also the ESMA consultation showed that there is a support for increased transparency on the methodologies used by proxy advisors and on their handling of conflicts of interest.[203] In particular most issuers considered that proxy advisors do not take into account local legal framework and practices, that they do not devote enough resources and that there is a lack of specific knowledge.[204] In this respect it is important to note that materials for general meetings are often only available 21 days before the date of this meeting and that most general meetings are clustered around a limited number of months from March to July.[205]

Where the methodologies used by proxy advisors to make their recommendations do not sufficiently take into account local market and regulatory conditions, the quality and the accuracy of the advice to investors is negatively affected.[206] This leads to a one size fits all approach in corporate governance, which negatively affects the corporate governance of listed companies. It is moreover to be noted that the suggested developments on enhanced shareholder rights (on remuneration and related party transactions) will result in an increase of their influence and work for a relatively small sector: the divulgation of methodologies used is a key element to assess the work they perform, both for the issuer which is the object of the recommendation and of the users of this information.

4.6. Obstacles to the exercise of shareholder rights

4.6.1. Identification of shareholders

The Commission’s Action Plan envisages to enhance transparency between companies and investors, encourage long-term shareholder engagement [207], but intermediated holding chains act as significant obstacles to shareholder engagement.

It is difficult for the company to identify who the shareholder is. Identification of the shareholder is essential to facilitate the exercise of shareholder rights as it is a prerequisite for direct communication between the shareholder and the company. The cooperation between the company and the shareholder is improved when the issuer can directly communicate with them. This strengthens corporate governance, e.g. through the direct casting of votes without the intervention of the chain of intermediaries.[208].

The identification of the shareholder in a domestic context is difficult in some Member States, e.g. the UK’s successful s.793 rule[209] may be effective but it is highly intensive and time-consuming. But the cross-border situation is even more cumbersome, particularly where multi-tiered holding chains cross several jurisdictions. The shareholders right to represent himself or to give instructions can only be realised if the link can be traced in a timely and reliable way. Although market practices vary widely, there are efficient national solutions for local shareholder identification in most markets, but a significant obstacle to cross-border identification is the legal uncertainty among foreign intermediaries as to if they can share their client’s data.[210] This is often brought to the Commission's attention: in public consultations, a number of stakeholders argued for a "shareholder identification principle"[211] and the Reflection Group on the Future of EU Company Law recommended allowing companies to identify their shareholders and directly communicate with them.[212] This is supported by 81% of issuers and 88% of investors.[213]

Example: An intermediary in the Netherlands, where there is no legal framework allowing Dutch company to obtain shareholders identification[214], may not be aware of the laws of another country, e.g. shares issued under Irish law, that requires shareholder disclosure and in any event may consider that their own local laws (e.g. on banking secrecy) may prohibit such disclosure. In effect, the Irish company has no means to identify its shareholders, even if the Irish law, under which the securities are constituted, gives him the right.

4.6.2. Cross-border transmission of information by intermediaries, including exercise of shareholder rights

There is wide-spread agreement among stakeholders that significant problems occur in the internal market regarding the cross-border exercise of rights attached to shares.[215] Investors face difficulties in exercising the rights flowing from their shares, especially if they are held cross-border. Such rights include, e.g. the right to attend meetings and to vote, to get a dividend, to participate in decisions on mergers, takeovers or stock splits and to challenge decisions of a company in court proceedings.

The longer the holding chain and the more intermediaries are involved, the higher the chance that information is not passed to shareholders from companies or that investors' votes get lost. This results in instructions given by shareholders to intermediaries to vote for shares held not always being executed. There is also a greater likelihood of misuse of the voting rights by intermediaries. Companies and shareholders have repeatedly raised these problems in discussions with the Commission and characterise them as recurring.

The exercise of rights from shares requires that shareholders get information and messages from companies on time, e.g. when deciding whether to approve a transaction to which the counterparty is a director, shareholders need to have details of the transaction including the price and the existence of other potential counterparties. Equally, information and messages from the shareholder to the company (e.g. voting instructions) need to reach the company to achieve its objective. There is general agreement among stakeholders that significant problems occur in the internal market regarding the cross-border exercise of rights attached to shares.[216]

Timely transmission of information (e.g. instructions) and rights (e.g. dividends), relies on the intermediaries in a holding chain,. Though dividend payments normally arrive to the investor, disenfranchisement from participation in the company's decision-making is widespread.[217] This is mainly due to jurisdictional differences in the levels of assistance given by intermediaries to clients and compliance with duties to send information.[218] So rights flowing from the shares may not be processed properly through the holding chain and the exercise of cross-border shareholder rights may suffer. Intermediaries suffer from the lack of standardisation of messaging from companies. Differing national standards on intermediary duties pose a high legal risk to intermediaries when they process corporate information; if it goes wrong, intermediaries can be exposed to financial risk.

4.6.3. Price discrimination by intermediaries for cross-border transmission of information, including exercise of shareholder rights

The problem of intermediaries who charge higher fees for cross-border transmission of information and the processing of rights was raised in the Commission's 2009 consultation. A large majority of the respondents replying to the question (companies/shareholders as well as intermediaries), considered that there are additional costs related to cross-border situations in case of need for information, as well as when trying to exercise shareholder rights. The size of the difference between domestic and cross-border costs ranged from an "insignificant increase" (from an Irish intermediaries association), through 30% higher for wholesale trades and 150% higher for retails trades (from an International Central Security Depository (“ICSD”), "for General Meetings from 200 to 300% more" (from 18 German listed companies), or "minimum 500% more" (according to UK intermediaries), to as much as a "dozen times more" (from the Polish Central Security Depository (”CSD”).[219] The scale of price discrimination acts as a deterrent to cross-border investment and the efficient functioning of the Internal Market. In the second public consultation, 20 stakeholders confirmed that they had encountered different prices for cross-border exercise of rights. The following examples were provided: specific fees were required for the registering of shares from France to Belgium (ECGS); a certification of holdings of a security (which is necessary to exercise the rights enshrined in the security) was more expensive if it involved a cross-border aspect (German issuers and investors); the cross-border exercise of voting rights was much more expensive, normally more than ten times, sometimes more than hundred times the cost of a purely domestic voting rights exercise (German issuers and investors). Furthermore, according to ECGS and ESH voting charges can reach up to EUR 150 per voting session. The request for a ballot (voting card) at a French general meeting in Germany may easily be charged with EUR 100 by the deposit bank whereas the request for a ballot at a German general meeting would still be free of charge for the shareholder. In a survey, 27% respondents indicated that they take cost of voting into account in making the decision to vote at a shareholder meeting.[220]

Price discrimination creates a barrier to the internal market as an intermediary’s services relating to passing on voting instructions become an indirect barrier for shareholders to vote and thus to be engaged. Stakeholders confirmed that they had encountered different prices for the cross-border exercise of rights. Two associations of intermediaries explained that their members applied different pricing models as the costs in the cross-border context were increased due to longer chains or different currencies.[221] Cross-border investment will continue to be discouraged by unjustifiably higher fees. This has the effect of reinforcing fragmentation and restricting investment to domestic opportunities.

4.7. Insufficient quality of corporate governance information

Article 20 of Directive 2013/34/EU requires listed companies to provide an annual corporate governance statement. This statement should provide essential information on the corporate governance arrangements of the company and in particular include a reference to the corporate governance code applied on a ‘comply or explain’ basis. Under the 'comply or explain' approach, a company which chooses to depart from a corporate governance code recommendation must give detailed, specific and concrete reasons for the non-application. These explanations require a company to reflect on its corporate governance and are used by investors to make their investment decisions.

The main advantage of this method is its flexibility as it allows companies to adapt their corporate governance to their size, shareholding structure, and sectorial specificities. This approach recognises that, in certain circumstances, non-compliance with certain recommendations might correspond better to the company’s interest than 100% compliance with the code. Appropriate disclosure of deviations from the relevant codes and the reasons for this reduces the information asymmetry between the company directors and its shareholders and decreases the monitoring costs. It also confers legitimacy to the company’s choice to put in place corporate governance arrangements which are not in line with the code’s recommendations.[222]

However, the ‘comply or explain’ approach is in practice not applied very well by companies. A study on monitoring and enforcement systems for Member States’ corporate governance codes[223] revealed important shortcomings in applying the 'comply or explain' principle. According to the study, the overall quality of companies’ corporate governance statements when departing from a corporate governance code recommendation is unsatisfactory. In over 60% of cases where companies chose not to apply certain recommendations, they did not provide sufficient explanation.[224] Although the study dates from 2009 information further analysis by the Commission and discussions with the European Corporate Governance Codes Network[225] on the application of the 'comply or explain' approach in 15 Member States shows that the situation has not improved significantly since then. In its 2012 report the UK Financial Reporting Council noted that “the standard of explanations is variable. Companies are generally better at setting out the background and actions taken to mitigate any governance concerns than they are at explaining the rationale for their decisions” and that “there were still many examples of generic and boiler-plate reporting”.[226]

Concerning the need to increase the quality of the information given by companies departing from the recommendations of corporate governance codes, an overwhelming support was shown by shareholders, asset managers and proxy advisors as well as by institutional investors that unanimously called for the measure. All stakeholders pointed out to the benefits that they could receive from receiving more information from companies. Additionally, also the majority of companies were in favour of more information. They asked for guidelines on what information is needed. The majority of Member States that answered to the question showed clear support for improving the system[227] however they suggested being careful not to increase the cost for companies. Some other Member States[228] support the objective, but believe it should be addressed without imposing new rules. Following on from the 2011 Green Paper, certain Member States, such as Finland, UK and Belgium have initiated discussions or issued guidelines on the quality of the explanations provided by companies.[229] However, such initiatives have only been undertaken in a minority of Member States. Consultations have shown that since then these problems have not been solved.

These deficiencies in the quality of corporate governance reporting make it more difficult for shareholders to take informed investment decisions. They also make engaging with and monitoring of companies more difficult and expensive, as investors do not have an adequate picture of the situation of the company and cannot on that basis engage in a dialogue with the company.

4.8. Which stakeholders are affected and how?

The combined impact that of the problems described above on different stakeholders groups (listed companies, shareholders, ultimate beneficiaries) is further analysed below.

(i) Listed companies

Companies are affected in a number of ways by the problems described above. First of all, the lack of shareholder engagement and possibilities to identify shareholders makes it difficult for listed companies to know what the objectives of its investors are. They have to rely on the signals given on the market. As shown above, in practice many institutional investors and asset managers focus on trading in the short-term, which puts pressure on companies to “respond” to short term share price movements.[230] Such short-term market pressure may lead to underinvestment and a company strategy focusing primarily on restructuring, mergers and acquisitions or financial engineering. In a survey of more than 400 financial executives, 80% of the respondents indicated that they would reduce discretionary spending on such areas as research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets. More than 50% said they would delay new projects, even if it meant sacrifices in value creation.[231] In a recent global survey of McKinsey and the Canada Pension Plan Investment Board, 63% of the business leaders said that the amount of pressure to demonstrate strong short-term financial performance has increased in the last five years. According to respondents a longer term view would increase innovation and lead to stronger financial results.[232] In this respect, a recent study on the effects of capital markets’ short-termism on levels of investments[233] documented sizeable differences in investment behaviour between listed and privately held companies. Listed companies invest substantially less (4 % of total assets, compared with 10% for observably similar privately held companies) and are less responsive to changes in investment opportunities compared to privately held firms, even during the recent financial crisis.[234] The study concludes that the most important factor lies in the agency problems affecting listed companies, and more probably, short-term incentives.[235]

Moreover, studies demonstrate that shareholder engagement on corporate governance issues is not only creating value for the shareholders[236], but contributes also to a significant improvement of the governance, operating performance, profitability and efficiency of the investee companies.[237] According to the most recent meta study on sustainable investing, 100 % of existing studies agree that companies with high rating for ESG factors (environmental, social and governance) have lower cost of capital and 89% of the studies show that such companies exhibit market or accounting based outperformace. Studies demonstrate that the governance aspect had the strongest influence and good governance leads to better financial performance.[238] Good corporate governance attracts investment, as certain investors have a preference for the shares of companies with good corporate governance.[239] Evidence shows that successful shareholder engagement actions of a US responsible investor increases the shareholdings of other asset managers and pension funds and leads to a decrease in the investee firm's return volatility.[240]

EVCA[241] considers that the key contribution to the long-term success of the companies in which private equity funds invest comes not only from the long-term duration of their holdings but, primarily from their active ownership and the long-term perspective they bring.[242]

In other words, the lack of sufficient shareholder engagement leads to suboptimal financial performance of listed companies.

The lack of transparency of proxy advisors has the effect that companies’ may have difficulty in understanding the reasons for certain voting recommendations, which makes it particularly challenging for them to react and explain its corporate governance approach on the relevant issue. This also decreases in practice their scope to decide what is for them the best corporate governance arrangement and might lead to ‘one size fits all’ corporate governance. The lack of a sufficient link of directors’ remuneration with (long-term) performance of the company leads to unjustified transfers of value of the company to directors and provides company directors with incentives that are not aligned with the interest of the company, which could be detrimental to financial performance of the company. Related party transactions have a negative impact on the value of the company, since they may lead to the unjustified transfer of value to the related party. Finally, the consequence of insufficient quality of reporting on corporate governance is that company boards are not stimulated to reflect on corporate governance, which might lead to inappropriate corporate governance arrangements, and, in view of the link between corporate governance and financial performance, might negatively impact financial performance of the company.

(ii) Shareholders

For institutional investors and asset managers the impact depends to some extent on their profile. Not all investors are or will be interested in the corporate governance of investee companies. However, for a growing group corporate governance is important for their investment decisions and engagement is a part of their efforts to increase the performance of their investments. Those investors need accurate and reliable information on corporate governance and tools to engage on these issues. The problem definition has shown that such information is absent, incomplete, difficult to understand or that doubts have arisen on their reliability (remuneration, related party transactions, proxy advisors, corporate governance reporting), which could lead to uninformed (investment) decisions and suboptimal corporate governance of the companies invested in. Moreover, tools are, according to stakeholders, missing to engage on issues such as related party transactions and remuneration.The effect on shareholders is that it is more difficult (and/or costly) for them to take informed decisions, especially in case of cross-border investments and that value is unjustifiably transferred to related parties and directors. As indicated in the above paragraph on listed companies, studies demonstrate that shareholder engagement on corporate governance, with remuneration being one of the key issues, may generate an average of 7-8% abnormal cumulative and buy and hold stock return[243] over a year.[244] By analysing companies’ fundamental value and long-term prospects and engaging on that basis, investors act not only in their own interest, but also fulfil an important social function by helping companies to take decisions that will contribute to their long-term success.[245]

The lack of certainty about whether or not votes get through the complex chain of intermediaries administering securities accounts and the disproportionately high cost of voting across the borders discourage shareholders to use their voting rights, which is one of the most efficient direct tools to exert influence on the management

(iii) Ultimate beneficiaries

From the perspective of ultimate beneficiaries, the impact of the insufficient engagement of institutional investors and asset managers, the lack of sufficient transparency and shareholder oversight on remuneration and related party transactions, but also the insufficient transparancy of proxy advisors and corporate governance reporting may also be considerable. The ultimate beneficiaries are, in most cases, not directly affected by these corporate governance problems, since they often do not directly manage their assets. However, these problems result in high costs of asset management, in lost potential for better corporate governance and thus for better results of the investments resulting finally in missed opportunities for growth, jobs and sustainability of the EU economies. In the end these problems have an impact on EU citizens who are future pensioners, insured, but also employees.

In particular, the cost of intermediation in the equity investment chain decreases the ultimate return to final beneficiaries from their investments. Studies say that active management fees and their associated trading costs based on 100% annual turnover erode the value of a pension fund by around 1.0% per year.[246] Pension funds are having their assets exchanged with other pension funds at a rate of 25 times in the life of the average liability for no collective advantage, but at a cost that reduces the end-value of a pension fund by around 30%.[247] EuroFinuse[248] considers that one of the root causes of the destruction of the value of pension savings is the misaligned interests within the investment chain and the high costs of intermediation. They highlight the case of a Belgian occupational pension fund which wiped almost a