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Anthony Hilton: Barring ailing firms from the index would boost investors

Carillion went bust
Carillion went bust / EPA
25 June 2019

ir John Kingman, one-time senior Treasury mandarin until losing out as permanent secretary to Tom Scholar a few years ago, is now ensconced as chairman of Legal & General.

One of his sidelines, courtesy of the Government, was to undertake an independent review of the Financial Reporting Council, to see whether that body was fit for purpose.

The FRC has been roundly criticised in the recent past for the scandals of Carillion and BHS among others.

Some thought it was trying to do too much and could not cope; alternatively perhaps it was trying to do too little or lacked the necessary resources. Whichever, Kingman would get to the bottom of it.

His report duly arrived this year, and it did not disappoint. None of the principals have said Kingman’s report was the reason for their discomfiture but Stephen Haddrill, the chief executive, decided it was time for him to resign, which he is in the process of doing.

Sir Win Bischoff, the chairman, has not offered to resign, or not publicly at any rate, but he will no doubt be off too as soon as there is a ready replacement. Even if Kingman’s report wasn’t the main thing, it meant it was the right time for them to go. But then what happens? Government seems only fixated with Brexit and its aftermath, and it seems likely it will not have much time for the FRC. The report may simply gather dust.

The FRC also looked this spring at the Stewardship Code, the document which talks about shareholder engagement with companies, to see whether it could be made more effective.

The Institute of Business Ethics thinks it could, but it would require one of Kingman’s recommendations to make it happen.

Recommendations 47 to 50 of Kingman would give the FRC powers to intervene in troubled companies. This would include the right to commission and publish independent reports, to review dividend policy and to require the replacement of the auditor.

Some might say shareholders should do this themselves, but they have consistently over the years failed to do so effectively. For example some institutional investors were perfectly aware of the difficulties facing Carillion, the outsourcer which went bust. Accordingly active investors such as Aberdeen Standard sold out of Carillion.

But passive investors, including the likes of Legal & General, were also perfectly aware of the problems and actively engaged but could not use the power precisely because of the growing prevalence of passive investment, where investors are locked in and cannot sell even if they wanted to.

The more pension fund money goes into passive funds, the more beneficiaries are at risk through this inability to sell out. And it is already around 30%.

This is a major problem but Peter Montagnon of the Institute of Business Ethics has a solution. It believes an effective sanction against companies that persistently and wilfully display poor governance should be that they should be excluded from the index.

Then everybody, including passive funds, would be free to sell.

The index providers would be told that it was no longer safe to compel passive funds to hold the company.

Montagnon has been in and around corporate governance for years at the Association of British Insurers, the Financial Reporting Council and now the IBE, so he knows what the problems are.

Of course, exclusion from the index would lead at once to a serious loss of value for the companies, but the point is that the sanction would be a deterrent.

Boards would know as soon as the FRC appeared that there would be real trouble if they did not respond and this would be a huge incentive on them to right wrongs, especially if the initial intervention by the FRC, or its successor was on a confidential basis.

The problem of having to hold shares, whether or not they want to, is a growing issue for trackers as they capture an ever-larger share of equity. The IBE’s comments are one way of addressing this. They deserve to be listened to.

All this, however, depends on implementation of the Kingman proposals.

Meanwhile, investors who are largely focused on passive funds should be clear that, though they cannot sell, they will use their rights to vote against director re-election.