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Iris H-Y Chiu

The chapter provides a comprehensive analysis of pan-European investment law. By providing an overview of European Union sources of law and regulatory objectives, he offers a thorough introduction to a large and growing market that rivals the United States in global economic importance. It explores the unique features of the two key pillars of European fund governance: UCITS (broadly corresponding to public funds like mutual funds in the United States) and Alternative Investment Funds (broadly corresponding to private US funds, such as hedge or private equity funds). It then offers an analysis of the future trajectory of European investment fund law.

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Investment funds in an era of financialisation

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

We discuss the rise of institutional fund management as part of the global trend towards financialisation. This context allows us to draw out the key characteristics of modern institutional fund management which are important in shaping their corporate governance roles. The context of financialisation allows us to appraise whether institutions behave like fiduciary or universal capitalists as some commentators have proposed, or self-interested agency capitalists, as suggested by others. Key words: financialisation, fiduciary capitalism, universal owners, agency capitalism, money manager capitalism, asset allocation.

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Roger M. Barker and Iris H.-Y. Chiu

We draw together broad level discussions in the structures and incentives in investment fund management, as reflecting a model of financialised business. We argue that most investment funds running a business model of pooled investments have structurally separated funds from managers for efficiency and regulatory reasons. This has further resulted in the growth and lengthening of the investment chain which has implications for the nature of investment management practice, including the assumption (or lack of assumption) of corporate governance roles for investment funds and their managers. The industry of professionalised asset manager is in particular susceptible to investor myopia and short-termism and is riddled with agency problems. Further, regulatory compliance pressures reinforce market preferences for these behaviours. However, these effects are also by-products of legitimate objectives in investor protection such as regular accountability and ensuring liquidity for investors. We query whether the embrace of ESG factors may change investment behaviour. We note that certain niche funds carry out different investment management practices, adopting ESG factors as a different ethos in their management. They come closer to an investment management paradigm that integrates savers’ long-term interests and the long-term wealth-creation role of the corporate economy. However, we do not think there are sufficient market-driven or regulatory forces that would compel such change to become mainstream. Hence, the model of investment management that the fund industry has developed raises considerable questions for the long-term objectives of meeting savers’ needs and supporting a long-term wealth-creating corporate sector. Key words: investment chain, asset managers, proxy advisers, socially responsible investing, investor protection, short-termism.

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Corporate equity ownership and misplaced hope in institutional shareholder stewardship

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

This chapter presents a high level perspective on the instrumental assumption of corporate governance roles by institutions, and shows that both neglect of such roles or the use of them in a self-interested manner by financial actors produces a mixture of beneficial and deleterious effects for investee companies. The desirability of promoting greater shareholder engagement in a world of institutional share ownership is far from obvious, and should not necessarily be seen as the key to an optimal system of corporate governance, as the UK Stewardship Code and the European Shareholder Rights Directive seem to assume. The awkwardly framed provisions in the new European Shareholder Rights Directive that are punctuated with public interest concerns regarding the nature and effectiveness of institutional investment management show that policy-makers have turned their attention to the governance deficits and issues in this area. We propose more comprehensive thinking about the governance and regulation of investment management practices, building upon the existing patchwork of UK and EU prudential and conduct of business regulation, but also more thoroughly to deal with issues hitherto unaddressed, such as the investment chain structuration and the role of the various entities of which it is composed, appropriate conduct in securities lending and, more broadly, the mitigation of agency problems and perverse incentives in the investment chain. Regulation may be the only means, albeit not necessarily perfect, to address the long-term needs of savers reliant on the investment management industry, and its impact on the long-term wealth-creating potential of the corporate economy. A soft law approach of shareholder stewardship which situates the underlying public interest notions in a private ‘corporate governance’ paradigm is unlikely to be an adequate one. Key words: Stewardship Code, shareholder activism, say on pay, short-termism, value extraction, long-termism.

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Pension funds as corporate governance actors

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

This Chapter provides an overview of public and private sector pension schemes, and the key factors that shape their investment management approaches and their corporate governance behaviour. A key aspect is funds’ reliance on asset managers to discharge their corporate governance roles. Asset managers are likely to professionalise and standardise notions of ‘stewardship’ for cost-effective engagement and to achieve at least an appearance of effective engagement with investee companies. We posit that such corporate governance roles are to be predominantly shaped by the interface between keeping investment management cost low while demonstrating, at least superficially, the achievement of shareholder stewardship to wider society. The likely dominant forms of stewardship will probably revolve around voting subject to proxy advisers’ recommendations and collective engagement organised around defensive concerns or norms in corporate governance but not amounting to polarised and confrontational relations with investee companies. However, we are of the view that opportunistic forms of stewardship are also welcomed by pension funds, as observed in their involvement in securities litigation, especially in the US, and some support for hedge fund activism. We remain sceptical as to whether pension funds and their asset managers can fulfil the aspiration of playing a corporate governance role that is necessary for the long term well-being of the corporate economy. Moreover, we also need to recognise that calling for pension funds and their asset managers to engage in their investee companies’ corporate governance need not be an unequivocal good. Instrumental exercises of corporate governance power could cause more harm than good. Key words: defined benefit pension schemes, defined contribution pension schemes, annuities, liability-driven strategies, voting, collective engagement.

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Mutual funds as corporate governance actors

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

Retail collective investment schemes that own corporate equities tend to be structured as UCITs and in this chapter we discuss how their corporate governance roles may be shaped by their structuration and by regulation. We are of the view that the investor protection objectives underlying regulation have inevitably shaped funds’ short-termist priorities. Such investor protection measures include redemption rights for investors, regular reporting and transparency, and governance in relation to cost and fees. But these measures have not made the corporate governance role of funds relevant to their business model of investment management. Funds face contrary driving forces in terms of shaping their corporate governance roles. The current concern with transparency and moderation in cost and fees could make shareholder engagement relatively expensive and even more unattractive. However, compulsion by regulation and market pressures make it difficult not to demonstrate some degree of engagement. Hence, we think regulatory compulsion to engage in such roles would go little further in encouraging funds to internalise such roles as an essential part of their business model. Funds are likely to regard such regulatory compulsion as part of compliance obligations, and outsource such compliance needs to be provided by, for example, proxy advisory agencies for voting decisions and entering into collective engagement. Regulatory imposition that forces funds to reckon with their corporate governance roles is unlikely to be the optimal way of encouraging the development of deep and committed corporate governance roles in a socially beneficial way, as discussed in Chapter 3. Ultimately, retail investors are themselves risk averse and relatively fickle. They generally support the investor protection regimes that have been instituted for their protection even if these may put short termist pressures on funds and entail short termist investment management behaviour. Investor clamour for exchange-traded funds is a testament to an ultimately deep disconnect between the beneficiary community and the investee corporations at the other end of the investment chain. Key Words: mutual funds, UCITs, active management, passive management, proxy voting agencies, exchange-traded funds, inducements.

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Hedge funds as corporate governance actors

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

Hedge fund activism is fundamentally instrumental towards the funds’ performance needs, and its strategies as well as duration of activism are shaped in the light of these needs. Performance and governance benefits have sometimes been entailed for certain investee companies that have succumbed to activist pressure, thus eliciting praise from some quarters for the effective market discipline that hedge funds have introduced to the sleepy landscape of corporate governance. The positive externalities generated by hedge funds are not universally accepted, as other research has shown, and we remain sceptical about viewing such activism as a manifestation of ‘stewardship’. The Stewardship Code’s endorsement of engagement escalation under Principle 4, where the investee company has not responded to informal engagement, seems approving of strategies that hedge fund activists use, such as demanding to meet members of the Board or even going public with grievances. However, the ‘wolf pack’ type of collective activism by hedge funds, seen largely in the US, would probably not align with the sort of collective engagement envisaged in the Stewardship Code. We acknowledge that hedge fund activism has provided, in some cases, the catalyst for change. However, as a model of corporate governance ‘entrepreneurship’ we think the beneficial tenets of stewardship upheld in the UK and Europe have provided checks upon the more instrumental aspects of their behaviour, and hedge fund activism has necessarily become more nuanced to respect the engagement norms that prevail in local markets. This could be crucial to the avoidance of externalities to stakeholders and undesirable disruption for companies. However, there should be no easy assumption of the public good consequences of such instrumental activity that is geared towards private profit-making in the short-term. In this respect, the importance of the Stewardship Code in normifying what is acceptable behaviour or otherwise cannot be understated. Key Words: hedge fund activism, disclosure, market for corporate influence, offensive activism, Stewardship Code, wolf-pack.

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Private equity funds and their corporate governance actors

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

In his 2014 letter to investors, legendary US investor Warren Buffet described private equity as a misnomer. In his view, the industry brands itself ‘private equity’ to divert attention from its primary focus on debt _ the 1980s’ terminology ‘leveraged buyout firm’ remains a more accurate description of such funds. In Buffet’s words: “In truth, ‘equity’ is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.” For the critics, private equity funds make money in an entirely instrumental manner _ by cutting jobs, taking on excessive debt, and passing on a fatally weakened enterprise after a few years following the extraction of massive fees. The role of private equity funds in their investee companies’ corporate governance is not inconsistent with the above business model. Nonetheless, private equity funds offer investee companies a far more engaged approach to ownership than their peers in public equity markets. Arguably, private equity is responding to the short-term pressures that afflict listed companies; it provides a safe haven which – for a while at least _ can be used to implement operational improvements that would not be tolerated if the shares were still exposed to the fluctuating sentiments or regulatory demands of capital markets. Although the approach taken by private equity fund managers is hardly akin to the stewardship philosophy described in the early chapters of this book, it nonetheless introduces a measure of ‘voice’ into equity ownership. Nevertheless, due to a lack of liquidity, private equity funds seek to exploit to the maximum possible extent the ownership and governance privileges that come with equity ownership, and are therefore a logical consequence of a governance system centred on the primacy of the shareholder constituency. Key words: private equity fund, leveraged buy-out, venture capital, management buy-out, de-listing, Alternative Investment Fund Managers Directive.

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Sovereign wealth funds and their corporate governance roles

The Promises and Limitations of the New Financial Economy

Roger M. Barker and Iris H.-Y. Chiu

SWFs, with swelling assets under management, are growing to become significant investors in developed capital markets. Although some fear that such investments are politically or strategically motivated and may bring negative consequences to the investee companies and host country markets, SWFs’ investments in foreign corporate equity, especially corporate equity in developed capital markets, can be attributed to the need for diversification from their economic models. Further, as SWFs seek to attain objectives that are beneficial to their own economies, such as stabilisation, savings and inter-generational equity, their investments in foreign corporate equity tend to be constructive, long-term oriented and stabilising in nature. In this light, the Norwegian Global Pension Fund, the world’s largest SWF, uses its investment strategy to pursue its wider mission of enhancing ethical and sustainable practices in the global corporate sector. Although some may see such a corporate governance role as supplying a useful collective good on behalf of most institutions, it can nevertheless be criticised as a projection of strategic state priorities onto global capitalism. Most SWFs therefore steer clear of assuming visible corporate governance roles, although the extent of informal influence that can be exercised remains opaque. We argue that SWFs have actually been behaving with great restraint in their corporate governance roles, perhaps more restrained than necessary, as it is impossible for them to shed suspicions of association with strategic or politically-driven behaviour, and their activist gestures, if any, could easily be magnified in a more negative light than is warranted. However, such behaviour stands in contrast to their corporate governance roles in domestic investments, usually as part of the government’s industrial policy. We do not think that adhering to the Santiago Principles would bolster SWFs in their corporate governance roles, as SWFs are likely to continue strategically complying with certain aspects of the Principles as far as they align with their interests. SWFs are unlikely to be able to become as objectively commercially-motivated as is demanded under the Principles, and perhaps they do not believe that thick compliance with the Santiago Principles will gain them much more favour in the markets anyway, as public perception is not a matter of rational judgment. Key words: sovereign wealth funds, strategic investment, ethical investment, Santiago Principles.

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Roger M. Barker and Iris H.-Y. Chiu

This chapter draws together the book’s proposition that urges policy-makers to move away from over-relying on the institutional fund management sector to deliver public-interest oriented goals in the corporate sector in their capacity as shareholders. It also suggests a sketch of corporate governance reforms that are much more pertinent to the corporate sector problems we experience today and calls for tough policy choices. Key words: Corporate Governance Code, long-termism, Kay Review, stakeholderism, company law.