The Fundamentals of Engagement

Firebrand Research’s Virginie O’Shea says it will take time for SRD II to deliver to European investors.

The European Securities and Markets Association (ESMA) opened a consultation this month asking for views on the efficacy of its shareholder rights guidance for EU member states.

First adopted in 2017, the revised Shareholder Rights Directive (SRD II) aims to “lay down a common regulatory framework with regard to the minimum standards for the exercise of shareholder rights in EU listed companies… to encourage long-term engagement in EU companies and thereby to enhance sustainable long-term value creation in EU capital markets”.

The directive, which came into force in December 2020, forms part of the Capital Markets Union’s ‘new vision for Europe’ which is designed to drive greater foreign investment into the EU and improve investor engagement.

The call for evidence – which closes on 28 November – focuses on four main areas: identification of shareholders; transmission of information; facilitation of shareholder rights; and transparency of proxy advisors.

ESMA says a consultation is necessary “for the collection of information from market participants in order to obtain a comprehensive overview of how stakeholders perceive the appropriateness and effectiveness of the current regulatory framework, to learn about the possible difficulties encountered in the course of its application and to understand relevant market developments”.

In short, is it helping investors engage effectively with companies?

Inconsistent interpretation

But according to Virginie O’Shea, Founder and CEO of Firebrand Research – who recently produced a report on the future of SRD II for technology provider Broadridge –the directive misses its mark.

“There hasn’t been as much benefit [to improving shareholder engagement] from SRD II as the institutional and the retail sides would have liked. It’s likely that some institutional investor bodies will push for change [as part of the consultation].”

Clearly defining a shareholder is central to the directive to make it easier for companies to identify and communicate with their investors.

However, since SRD II is a directive rather than a regulation, it has been interpreted differently by national competent authorities across the EU.

The Firebrand research reports: “This divergence in interpretation reflects the fact that the definition of shareholder varies from country to country within the region, which makes the fundamental application of the directive challenging from the start. In practice, this means that the identification of the person that is entitled to receive and exercise shareholder rights depends on the corporate law in each different country.”

O’Shea says this lack of clear definition means mistakes are made in the voting process.

“Unless you have a consistent way of identifying the shareholders it becomes problematic, because people can get confused. We are dealing with cross-border environments and the wrong information can get passed up and down the chain,” O’Shea says.

Undermining corporate governance

In recent years, growing awareness of ESG risks means shareholders have been increasingly instrumental in shaping companies’ environmental policies and in determining director remuneration.

Early analysis of the 2022 proxy voting season from Sustainalytics found: “Engagement dialogues are expected to take on a new level of intensity [compared with 2021]. Sensing stronger voting support, management teams and boards may be more motivated to meet shareholders’ requests to secure withdrawal of the resolutions. On the other hand, where investors are more confident of a strong vote outcome, they will likely be expecting a higher degree of commitment from the companies they engage with.”

But if the EU directive fails to enforce the basics of shareholder engagement effectively, then the fundamentals of effective corporate governance risk being undermined.

The apparent inadequacies with SRD II have, O’Shea says, resulted in votes failing to reach their intended destinations.

“The noted differences often cause numerous systemic and automated vote rejections due to ad hoc intermediary processing. Intermediaries may reject votes due to inconsequential formatting infractions, which, in turn, causes votes to be delayed and therefore to potentially miss voting deadlines.”

Slow progress

ESMA’s efforts to overhaul shareholder voting rights has also been hampered by custodians and other asset servicing companies’ slow transition to digitised systems.

Positive changes have been made. O’Shea notes that “connectivity between market intermediaries has evolved to facilitate the timely transmission of sensitive information such as shareholder identity”, adding that “some intermediaries, particularly retail banks and brokers, have had to implement brand new technology and connectivity as a result of the need to provide their underlying clients the ability to vote at issuer meetings”. Nevertheless, many players continue to rely on legacy systems that cannot keep pace with the updated directive.

But O’Shea says this is the fault of the regulators rather than the intermediaries, arguing they were not given requisite time to get compliant IT systems in place.

“Nearly every intermediary had problems because the central securities depositories (CSDs) didn’t get the heads up from the regulator as soon as they should have with regards to the directive’s implementation deadline. The CSDs didn’t start testing systems in time, so custodians didn’t start their projects in time. And then obviously you’ve got brokers who need to comply, as well as intermediaries.”

Most shares are held at national or international CSDs, placing them at the heart of all processes relating to share ownership and control, including voting and engagement.

She continues: “The issue here is that everybody was slow. It didn’t help that the directive happened during the pandemic.”

O’Shea welcomes ESMA’s call to evidence, arguing that it provides an opportunity to provide consistency on definitions of ‘shareholder’ but also to demonstrate a willingness to crack down on local regulators that are not effectively implementing the directive.

“ESMA needs to take a harder line on the local regulators. It’s not just the asset servicing firms that you need to look at here. [ESMA] can go directly after national competent authorities if they feel that they’re not taking EU level directives and regulations seriously,” she says.

However, O’Shea does not expect change to the directive any time soon.

“The EU bodies have a lot of plates spinning at once and while we were told to expect a response to the consultation early next year, I wouldn’t be surprised if that is pushed down the road.”

What is SRD II?

SRD II is a part of the Capital Markets Union (CMU), an initiative championed by the EC to regulate the financing of European infrastructure.

SRD II’s goal is to strengthen shareholders’ rights, reduce risk-taking across the capital markets and improve corporate governance in companies with securities traded across regulated markets in the EU.

SRD II makes significant changes to the original directive’s Article 3 giving companies the right to identify their shareholders. This creates an obligation on intermediaries to transmit the necessary information they hold on shareholder identity.

Article 3 also requires intermediaries to transmit relevant information from the company to the shareholder to facilitate their exercise of shareholder rights. Intermediaries must publicly disclose what they charge for these services and costs must be proportionate.

For institutional investors and asset managers, there are additional requirements to publish an engagement policy and disclose annually how the main elements of their investment strategy contribute to the medium to long-term performance of their assets.

Proxy advisors must adhere to a code of conduct and disclose information to show how their voting recommendations are accurate and dependable.

Shareholders have the right to vote on remuneration.

Executive remuneration and related party transaction information must also be made available.

Source: BNY Mellon, SWIFT, ESMA

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