'The failure of the Royal Bank of Scotland'

Even the title of this report carries the sense of gloom that fell upon the streets of many of the cities and towns in the UK in the autumn of 2008. Royal Bank of Scotland, one of the world's largest banking groups following its acquisition of National Westminster Bank at the end of the 1990s, had gone too far when it led a consortium of bank to buy and break up the Dutch bank ABN Amro. That deal – combined with the subprime crisis - was its undoing. Three years later, and after much prodding, the Financial Services Authority has released a blockbuster report – detailing the bank's and the regulator's failings – in the affair. While the global market context played an important role, the FSA devoted consideration space to the problems of leadership and governance at RBS, and noting: "banks are run by people and those in board and senior management positions are responsible for the decisions they make. It is only with hindsight that it is clear that there were specific decisions taken by the RBS Board and senior management which placed RBS in a more vulnerable position than other banks when the financial crisis developed between 2007 and 2008." The expression "only with hindsight" may be that the regulator's foresight wasn't very good at the time, when quite a few people, including some shareholders, wondered whether RBS had taken a step too far. The FSA says that beyond the mistakes in the ABN Amro takeover, the errors at the top included:

• Capital: Keeping RBS lightly capitalised in order to maintain an "efficient" balance sheet.
  
• Funding: Adopting a business model that was highly dependent on wholesale funding and therefore choosing to run with a high level of liquidity risk.;
  
• Lending: Expanding commercial real estate lending with inadequate monitoring and mitigation of concentration risk.
  
• Asset allocation: Rapidly increasing lending in a number of other sectors which subsequently gave rise to substantial losses, eroding RBS’s capital resources.
  
• Structured credit: Expanding the structured credit business in 2006 and early 2007 when signs of underlying deterioration in the market were already starting to emerge.

These are first-level errors, but they point to underlying factors that made them systemic. The FSA inquiry went beyond board minutes, pursuing through interviews and other means to reach a view about how the culture, management and governance led to such a catastrophic situation. It does not make happy reading, especially for a bank that nominally complied with pretty much all the demands of the UK Combined Code.

"The FSA announced in December 2010 that, in the context of its enforcement work:

'We did not identify …… a failure of governance on the part of the Board.'

"However, it is important to note that this conclusion was reached in the context of whether there was a basis for the FSA successfully to bring an enforcement case in relation to the issues that were investigated," the FSA continues. "It should not be regarded as providing a positive assessment by the FSA of the general quality of corporate governance at RBS during the Review Period." Perhaps that's another sign of the failings at the FSA.

Source document: The index page for the report provides links to a section-by-section breakdown as well as the full 452-page document.

SEC chairman wants better 'engagement', whatever that is

Mary Schapiro has been a regulator and a board director. As chairman of the US Securities and Exchange Commission, she's in charge of drawing up rules that govern the relations between companies and their shareholders and she thinks better engagement is a good thing. The problem is, she doesn't know what it means. "Effective engagement is a strong positive. But, in attempting to foster effective engagement we face a challenge: the definition of 'effective engagement' is imprecise," she told the Transatlantic Corporate Governance Dialogue, a conference of practitioners, regulators and academics. "In fact, the definition of effective engagement can vary significantly from company to company, as investors and boards interact in very different ways, but achieve similarly positive financial results and equally satisfying relationships between shareholders and boards," she added.

The SEC is trying to define it, at least in part, by looking again at disclosure, but also at voting processes. It is considering whether to regulate the proxy advisory industry and perhaps doing something about ensure vote confirmations are more fixed. It's looking into enhanced disclosure concerning beneficial ownership and the reporting of equity swaps, too.

Source document: The Schapiro speech gives further details.

There's more to corporate governance than governance

Annie Pye is one of those academics who pick a topic and won't let go. Back in 1988 she started interviewing directors of UK corporations, work that continued a decade later once the Cadbury Code had come to dominate UK board practice. Her team at the University of Exeter has been at it again. This is not just a random sample survey approach. In many cases they have been talking to the same senior people for decades. The latest version comes with a quantitative element, focusing on boardroom and executive pay, and well as profiles of board composition. Her work details how each major corporate scandal has led to increased regulation. Each cycle of boom and bust has been succeeded by wider, deeper and longer-lasting recessions. "Ever more regulation shows an increasing trust in a system of rules rather than in the people who run companies. If this pattern persists then perhaps the next step is global regulation which my research shows is neither feasible nor desirable," she notes. "In other areas very little has changed – the number of women on boards remains pitifully low and the relationship between Chief Executive and Chairman remains crucial and defines the effectiveness, or otherwise, of boards."

Non-executives: The report notes that regulatory changes may have sharpened the role of non-executive director, but they have "also exacerbated its paradoxes". Non-execs must be coaches and referees, support and challenge, and remain independent even as they share hopes and aspirations with the executive with whom they serve.

In this uncomfortable state of affairs, corporate governance still seems important, but the report concludes – as her previous work did – that codes and regulation may be necessary, but they aren't sufficient for board effectiveness. "There is more to corporate directing than corporate governance," the latest report concludes. "Responsibility for setting direction/strategy, risk management, leadership, corporate conduct, reward and incentives, reputation and performance remain key elements of a director's governance role."

That is, there's more to corporate governance than corporate governance.

Source document: The synopsis of the report is a 12-page pdf file.

Olympus should 'remove its malignant tumor'

The investigation by a committee of prominent outsiders recommends large changes in the culture and governance of Olympus Corp., the Japanese camera-maker caught up in a crisis after firing its new CEO for questioning payments and acquisitions made by his predecessor and approved by the board. When the scandal broke, the board belatedly appointed what it called the "Third-Party Committee", a team of lawyers and accountants headed by a retired judge, to find out what had happened. Though the report was not comfortable reading, it gave some succour to the workforce: "Olympus had originally been a sound company, with diligent employees and high technical strength. Not all part [sic] of the company was involved in this misconduct," the committee's report concludes, with the following sting in the tail: "Olympus should remove its malignant tumor and literally renew itself."

Source document: The Third-Party Committee report is a 38-page pdf file, in its unofficial English translation.

Voting disclosure too much of a good thing?

Pension funds would seem to be the archetypal investor in equity markets. They hold assets for long periods and look for sustainable investments, and they are thus the natural partners for strategic conversations with corporate management. Mutual funds, by contrast, are vehicles for shorter term performance, and mutual fund managers become obsessed by – because their clients obsess about – the latest quarterly fund performance metrics. They are natural shareholder activists, demanding that corporate management stays on its toes, delivering the numbers every three months. But there's a problem, one long noted among both theoreticians and policy-makers: Mutual fund managers often administer corporate pension funds. There's a danger they will tone down their activism for the sake of winning and retaining pension fund business, and use their proxy votes in a pro-management manner, thus hindering shareholder value. Such concerns led the US Securities and Exchange Commission to require that mutual funds disclose their proxy votes, starting in 2003.

A study at the London School of Economics has come up with a model of mutual fund proxy voting in the presence of potential business ties, suggesting how funds would vote both prior and subsequent to mandatory disclosure. It claims to "demonstrate that mandatory disclosure is not a panacea". Moreover, the strategic interaction between multiple mutual funds holding blocks of shares of comparable size can generate counterintuitive relationships.

"These findings raise the question of whether disclosure is a desirable regulation, even from the perspective of those in support of shareholder activism," they suggest.

Source document: The working paper "Delegated Activism and Disclosure, by Amil Dasgupta and Konstantinos Zachariadis of the London School of Economics, is a 38-page pdf file.

Activism - Can't walk? Can't run? Hide?

It's long been argued that institutional investors are the natural safeguard against managerial opportunism. Institutions hold blocks of shares large enough that their voices are taken seriously by management. Even those that choose not to engage actively can have an effect through what a now-famous research paper once called the Wall Street Walk. It's a catchy title for a simple phenomenon: If they don't like what a company's management is doing, shareholders can sell their shares and go away. The argument about the Wall Street Walk is, however, that if the blocks of shares are big enough, and if management is conscious of share price developments, then corporate governance exercised through "exit" can be as effective as when it's undertaken by "voice".

Now a new study has shed some doubt on those conclusions. Very often a shareholder in possession of the block isn't really the principal, but rather another agent in a long chain of agency. "How do agency frictions arising from the delegation of portfolio management affect the ability of blockholders to govern via the threat of exit?" the researchers wonder. "We show that when blockholders are sufficiently career concerned exit will fail as a disciplining device. Our results have testable implications on the relative degree to which different classes of delegated portfolio managers use exit as a form of governance."

It's worth noting that the "blockholders" mentioned aren't the ones we know so well in continental Europe. Holders of very large, controlling stakes often can't exit at all, but they certainly can exercise voice.

Source document: The discussion paper "The Wall Street Walk when Blockholders Compete for Flows", by Amil Dasgupta and Giorgia Piacentino of the London School of Economics, is a 42-page pdf file.

Selective access remains, even after 'end' of selective disclosure

Regulation FD – for "fair disclosure" – was meant to have ended the pernicious effects of selective disclosure in the US equity market, but there are signs that the benefits of selective access remain. Investors continue to seek the chance to meet corporate managements and quiz them about their plans, even though executives are under strict orders not to stray from the official story. Regulation FD came into force in the US about a decade ago, one of the reactions to the dot-com bubble, when stocks were being ramped up by investment banks, bought and then dumped by investors-in-the-know. In its aftermath, the authorities in jurisdictions around the world either introduced or tightened their own disclosure obligations to create a new ethos of openness. It led to a wave of webcasting and similar other measure to use technologies to prevent some people learning more than others. Everyone should know all, or at least everything that anyone knew.

So what's happened in the intervening decade? A study by three US scholars has examined the practices surrounding two potential opportunities for selective access, even if they may not confer selective disclosure:

• Conferences: Invitation-only investor conferences, where senior managers present the company's plans and positions.
  
• Roadshows: Formal "offline" meetings that outside of the webcast presentation and CEO attendance at the conference.

"We find significant increases in trade sizes during the hours when firms provide off-line access to investors and after the presentation when the CEO is present," they write. This result is consistent with selective access providing investors with information that they perceive to be valuable enough to trade upon, they conclude. Significant potential trading gains occur over three- to 30-day horizons after the conference for firms providing formal off-line access, suggesting that this selective access is profitable, too. "While we cannot conclusively determine that managers are providing selective disclosure in these off-line settings, our evidence does suggest that selective access to management conveys more benefits to investors than public access even in the post-Reg FD period," they write.

Source documents: A discussion of the findings appears on the Knowledge@Wharton website. The working paper "Do Investors Benefit from Selective Access to Management?," by Brian Bushee of Wharton, Michael Jung of New York University and Gregory Miller of the University of Michigan, is a 53-page pdf file.