"Anachronistic" Kay report on equity markets will not necessarily lead to more responsible investment, expert warns

Out-Law News | 25 Jul 2012 | 3:47 pm | 2 min. read

Poorly-targeted incentives and public mistrust of a culture based on transactions and trading have created a "culture of short-termism" on the stock market, according to a Government-commissioned report.

A report (113-page / 630KB PDF) aimed at encouraging long-term decision making, commissioned from Professor John Kay by the Department of Business, Innovation and Skills (BIS), proposes a new system of long-term performance incentives for company directors to be held as shares in the company at least until the director has retired. He also recommends the wider application of fiduciary standards within the investment chain and the establishment of an 'Investor Forum', to encourage more effective engagement between investors and companies.

"A lack of trust, and poorly aligned incentives, have helped create a culture of short-termism in our financial markets," Kay said. "This is undermining their role of supporting innovative, sustainable long-term business performance. We must create cultures where businesses and finance can work together to create high performing companies and earn returns for investors on a sustainable basis. This means moving away from a focus on short-term transactions and trading to an environment based on long-term trust relationships."

He added that his proposals were not about "more regulation", but rather designed to ensure that the existing regulation of market structures and incentives systems "work properly for the real end users". The report sets out statements of good practice which Kay recommends be adopted into "clear and specific guidance", rather than "detailed regulation".

However corporate law expert Sean Page of Pinsent Masons, the law firm behind Out-Law.com, said that the report was "anachronistic and a function of its political origin" – as a means of tackling the general public's mistrust of the way in which stocks and equities are traded.

"There is now an entire industry with quantitative analysts boasting PHDs who are employed specifically to trade the market short or exploit short-term market anomalies," he said. "I am sure most people would agree that incentivising corporate officers to create short term profit feels morally wrong and encourages risk-taking, but the net effect will surely be to drive those individuals into roles where they will be remunerated for taking exactly those sorts of risks."

Business practices identified as evidence of "short-termism" by the report included a tendency to under-invest - whether in physical assets or more intangible aspects of the business such as product development, employee skills and reputation with customers - and "hyperactive behaviour" by executives involving financial reengineering or mergers and acquisitions at the expense of long-term strategy. A "wide variety" of companies had, the report said "made bad long-term decisions" influenced by short term gain on the markets.

"We conclude that the quality – and not the amount – of engagement by shareholders determines whether the influence of equity markets on corporate decisions is beneficial or damaging to the long-term interests of companies," the report said. "And we conclude that public 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."

The report was commissioned by Business Secretary Vince Cable in 2011 to consider how equity markets, on which shares are issued and traded, could be better used to enhance the performance of UK companies and enable investors to benefit from sustainable returns. Kay was asked to consider the relationships between different types of investors including individuals, pension funds, their advisers and managers and the markets and company boards.

Cable said that the final document "vividly" described the flaws in the UK's current system.

"Since becoming Business Secretary I have been a vocal advocate for a new model of responsible capitalism based on creating long-term value rather than short-term profit," he said. "Equity markets have a vital part to play in ensuring we have well run companies providing sustainable returns for investors. This report is an important and timely contribution to the discussion of how we achieve this."

The Government would, he said, respond to Kay's recommendations later in the year.