How to Drive Long-Term Thinking by Boards and Managements

Millions watched as Olympians in London set several fresh world records in various events. 

Days before the opening ceremony corporate governance found something of its own to celebrate just a few miles down the road from the Olympic complex. The Kay Review on short-termism may have gotten buried by mid-summer news fatigue and the avalanche of Olympics reporting on such stars as Michael Phelps and Usain Bolt, but make no mistake: Economist John Kay's conclusions carry global implications and are a must-read, not just for governance professionals everywhere, but perhaps for anyone who cares about the future of capitalism. (An online version of the report can be found at http://www.bis.gov.uk/kayreview.)

So who is John Kay, and why should we care about his report? Kay is an incisive economic scholar and columnist known for his blistering critiques as well as for the arresting baritone he uses to makes his observations during radio and TV commentaries. When U.K. Business Secretary Vince Cable unexpectedly tapped Kay to conduct a probe into how to promote long-term decision making in boardrooms, observers predicted that Kay's final product would break new ground. And when it was published in late Aug., they were not disappointed.

Thank Irene Rosenfeld, CEO of Kraft Foods for stirring Cable to commission the report. In 2010 the food giant launched an effort to acquire the iconic British chocolate maker Cadbury. Barred under British practice from mustering takeover defenses, big long-term investors fled, leaving Cadbury largely controlled in the end by fast-buck hedge funds. Rosenfeld won final grudging approval for the takeover from regulators by promising to retain jobs in the United Kingdom. It took Kraft little time to break these pledges, however, with Rosenfeld declining twice to explain company decisions before an aroused parliamentary committee.

Kay's overall reform agenda rests on a simple principle: “incentives to do the right thing” are more effective than trying “to prevent people who are subject to inappropriate incentives from doing the wrong thing.”

Kraft's actions helped make Cadbury—whose former leader Sir Adrian Cadbury lent his name to the world's first major corporate governance code—into a U.K. symbol of boards dancing destructively to the tune of short-term funds. Within weeks of Rosenfeld's last refusal to testify in Westminster, Cable turned to Kay for solutions.

Concern that boards are too beholden to short-term results at the expense of long-term thinking is as widespread in the United States as anywhere.

In fact, the Angelides Commission fingered the phenomenon as a key trigger of the financial crisis. Moreover, little has been done to fix the problem. So Kay's conclusions could have important spillover implications here, once they are absorbed. Here are the major findings of the Kay report:

Shareholders drive companies to behave either short- or long-term oriented; but market incentives today push unhappy longer-term investors to dump stock early instead of staying and engaging with directors. So short-term thinking wins. Moreover, middlemen such as asset managers have come to dominate buy, sell, and voting decisions. Industry practice prompts them to focus on short-term performance relative to rival firms rather than the fundamental value of portfolio companies.

Short-termism delivers a double whammy: Boards starve the firm of investment in research, employees, or reputation, while executives engage in “financial re-engineering … at the expense of developing the fundamental operational capabilities of the business.”

Equity markets aren't really used much any more to raise cash—but trading is key to determining which investors wind up with responsibilities to oversee executives. “Promoting good governance and stewardship is therefore a central, rather than an incidental, function” of an equity market.

The assumption that more disclosure prompts healthier behavior—a core doctrine animating the U.S. Securities and Exchange Commission—puts what Kay calls “exaggerated faith” in the market. The result: We get “large quantities of data, much of which is of little value to users.”

Law and regulation should apply fiduciary standards to all participants in the equity chain, compelling them to put client interests first. That's a Jack Bogle idea now being mulled in the United States by the SEC.

Shareowners should be provided clarity that fiduciary duty permits them to incorporate long-term “intangibles”—such as environmental, social, and governance factors—into investment decision making.

Boards should structure incentive pay for executives to support “sustainable long-term business performance” by, for instance, awarding shares “to be held at least until after the executive has retired from the business.”

Funds should have a clearer picture of fees paid to financial agents and should gain assurance that fund-manager pay is aligned with “the interests and timescales of their clients.” The International Corporate Governance Network's recent “Model Mandate” offers a template for modernizing this relationship. (The mandate can be found online at: https://www.icgn.org/images/ICGN/Best%20Practice%20Guidance%20PDFS/icgn_model_mandate_mar2012_short.pdf.)

Investors should talk to boards about governance not in a narrow sense but in the context of broader strategic issues. That's a barb aimed especially at investment houses that feature separate silos of portfolio managers and governance professionals. And, Kay says, investors should trim their holdings to improve their capacity to perform meaningful analysis and oversight. In that aspect, he mirrors the Warren Buffet philosophy of investment rather than the embrace of indexation and quantitative techniques that has characterized U.S. capital markets for the past quarter century.

Boards should routinely consult with their “major long-term investors” about new director nominees.

Kay's overall reform agenda rests on a simple principle: “incentives to do the right thing” are more effective than trying “to prevent people who are subject to inappropriate incentives from doing the wrong thing.”

While identifying several problems, the review does fall short in vital areas. For instance, Kay advocates more meaningful, collective engagement with companies by investors, but fails to tackle flaws in the governance of funds that impede such action. Still, its call for a change in behavior by investors and regulators is likely to provoke advances. Cable, for his part, is due to respond with legislative proposals—for instance, on fiduciary duty—in the next few months.

What does all this mean for governance in the United States? Well, Kay's diagnosis is just as relevant here, if not more relevant. Too many asset managers act in a way that is out of alignment with the interests of long-term beneficiaries. Portfolio-manager pay is short term; fiduciary duties they apply are either absent or obsolete; and engagement with boards is rare and often disjointed or misinformed. Moreover, the market-based U.K. solutions Kay advocates—for instance, a strengthened voluntary Stewardship Code, or important initiatives such as “2020 Stewardship” (which can be found online at http://www.forceforgood.com/Uploaded_Content/tool/2132012172742724.pdf) —are nowhere to be found in the United States just now. The investment community may be too large, fragmented, and leader-challenged to see this approach take off in the immediate future. But the new ICGN Model Mandate could trigger retirement fund attention, and it has the potential to rework timeframes. Similarly, an SEC decision on fiduciary duty applying along the investment chain could spark behavioral change. The battle over fiduciary standards for brokers suggests that such a reform will be difficult to implement in the near future; but reform advocates are committed to this issue for the long run.

Maybe the most critical implication to be drawn from Kay's report, though, is this: U.S. companies and collective agents such as the U.S. Chamber of Commerce have consistently fought public policy measures to enhance investor authority. Kay finds, in contrast, that the best approach for long-term corporate success is to foster an investor community that is strong enough to put long-term client interests ahead of the short-term commercial imperatives of the middlemen who actually invest their assets on a day-to-day basis. Bringing corporate and investor leaders together around an agenda to better serve both long-term investors and corporate America would indeed be a worthy Olympian feat.