Since 2010, the UK’s Stewardship Code has encouraged institutional investors to proactively engage with the boards of the companies in which they are invested (issuers) to pre-emptively identify and resolve strategic problems, and ensure that those companies are managed successfully, through ‘issuer-specific engagement’, However, following John Kingman’s review of the Financial Reporting Council, which doubted the effectiveness of the Stewardship Code in encouraging informed and engaged stewardship, a substantially updated version of the Stewardship Code was released in 2020. In this working paper (forthcoming in The Modern Law Review), I discuss that, although in relation to encouraging issuer-specific engagement of the type originally envisaged by the 2009 Walker Review, the Stewardship Code may be doomed to failure, the concept of ‘stewardship’ may not be completely dead in the water, a fact perhaps tacitly acknowledged by the broader scope of the 2020 version of the Code.

Institutional Investors comprise asset owners, such as pension and investment funds, which invest funds on the behalf of ‘beneficiaries’, and asset managers, which manage those funds on behalf of asset owners. If issuer-specific engagement does take place, it is undertaken by asset managers, and, therefore, the asset management industry is critical in assessing stewardship. Asset management can be broadly divided into three strategies: passive investment, whereby asset managers slavishly track a designated index such as the FTSE-100, defensive active investment, whereby asset managers actively make buy, hold and sell decisions, and offensive activism, whereby asset managers invest in issuers based upon the potential to instigate value-creating changes within the relevant issuer.

The incentive for passive investors to undertake issuer-specific engagement is negligible, since they are heavily diversified and have little in the way of resources to proactively and adequately identify areas of concern on an issuer-by-issuer basis. Moreover, their business strategy simply entails tracking indices with the minimal level of error to create low-cost investment opportunities for their clients: a poorly performing company within that portfolio will not affect the capacity of the passive investor to track the relevant index accurately. Defensive active investors, on the other hand, could generate value by ensuring that individual issuers within their portfolios are maximising shareholder value. However, as with passive investors, such active investors pursue diversified investment strategies, usually only holding small interests in individual issuers, and to the extent that any engagement by the asset manager successfully generates value, all its competitors who are invested in the same issuer can free-ride on the gains while the engaging asset manager suffers the entirety of the costs of engagement. As such, the Stewardship Code’s urgings can lead to issuer-specific engagement only taking place on a shallow governance-related basis, or, at worst, to detrimental box-ticking behaviour.

Even if a defensive active investor were to identify scope for genuine issuer-specific engagement, the uncertainties of success in conducting that engagement will more likely lead to the investor selling rather than engaging, unless the investor is significantly ‘overweight’ in the issuer. However, it is unlikely that an investor will become so overweight in an issuer that the benefits of engagement outweigh the costs, unless the investor has committed to engagement prior to investment as part of so-called offensive activism. Offensive activists, such as hedge funds, identify investment opportunities ripe for shareholder value-generating change before making the relevant investment. Accordingly, becoming overweight in the relevant issuer forms part of the investment strategy of the asset manager, and focused issuer-specific engagement becomes apposite. Offensive activism is the primary avenue for issuer-specific engagement. However, it does not resonate with the proactive monitoring of, and engagement with, existing investments as propounded by the Walker Review and successive versions of the Stewardship Code. In the paper, I argue that no matter one’s pre-disposition toward hedge fund activism, it is the only type of issuer-specific engagement likely to occur where the Stewardship Code is applied on a voluntary ‘soft-law’ basis. Issuer-specific engagement of this sort is ingrained in the business strategy of offensive activists, and, therefore, the Stewardship Code does not, and will never, have substantive influence on their behaviour. Yet, offensive activism can only be successful with the backing of passive and defensive active investors, since offensive activists will generally not hold sufficient voting rights in an issuer to instigate change unilaterally. I discuss how the Stewardship Code should acknowledge this reality and, instead, prioritise the types of disclosure that will be useful for asset owners and beneficiaries in this regard.

Moving beyond issuer-specific engagement, in the paper, I discuss that the only other type of engagement likely to occur in practice is ‘holistic-risk engagement’ whereby investors engage on matters that could impact multiple issuers within a portfolio, such as climate-change, economic downturns, and global pandemics. Engagement on these matters, for defensive active investors, is realistic, since, if successful, it can create substantial value across the portfolio as a whole (or to the extent engagement is not successful, the investor can sell the relevant investments). In addition, its costs can be low, comprising simply of insistence on specific disclosures or specific risk-mitigation measures. Passive investors can also piggy-back off such initiatives on a low-cost basis by supporting relevant holistic risk matters through the exercise of votes, which may even occur on an institutional basis where a single asset manager pursues both active and passive strategies. As noted in the paper, holistic-risk engagement does, in fact, occur in practice, with huge asset managers, such as BlackRock, focusing on these matters in recent years. In the paper, I discuss how the Stewardship Code could better accommodate the new normal and note that the Code has moved part of the way there in its 2020 incarnation with environmental, social and governance (ESG) and systemic risks becoming more pervasive within the Code.

The Stewardship Code may never satisfy the aspirations of the Walker Review or palliate the concerns of Kingman. However, unless it is too late, if future versions instead focus on the types of engagement that do actually occur, unlike the Emperor’s clothes, the impact of the Stewardship Code could become more than merely illusory.

Bobby Reddy is a Lecturer at the University of Cambridge and a former law firm partner.