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The International Lawyer

The International Lawyer, Volume 55, Number 1, 2022

Governing the Purpose of Investment Management: How the 'Stewardship' Norm is Being (Re)Developed in the UK and EU

Iris H-Y Chiu


  • Since the development of the UK Stewardship Code in 2010, as a result of both private sector and public sector coordination, the practice of institutional shareholder engagement has become “normified" for investment management conduct in the UK and globally.
  • Commentators show that such “normification" is not limited to the UK, as bodies with transnational reach such as the International Corporate Governance Network (ICGN) and European Fund and Asset Management Association (EFAMA) have also spurred the global normification of shareholder engagement as stewardship and have influenced the adoption by many jurisdictions of Stewardship Codes.
  • But over the last decade, a plethora of critiques have been levied at institutions in relation to how the expectations of stewardship have beenmet (or otherwise).
Governing the Purpose of Investment Management: How the 'Stewardship' Norm is Being (Re)Developed in the UK and EU

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I. Introduction

Since the development of the UK Stewardship Code in 2010, as a result of both private sector and public sector coordination, the practice of institutional shareholder engagement has become “normified” for investment management conduct in the UK and globally. Commentators show that such “normification” is not limited to the UK, as bodies with transnational reach such as the International Corporate Governance Network (ICGN) and European Fund and Asset Management Association (EFAMA) have also spurred the global normification of shareholder engagement as stewardship and have influenced the adoption by many jurisdictions of Stewardship Codes.

But over the last decade, a plethora of critiques have been levied at institutions in relation to how the expectations of stewardship have been met (or otherwise). Such critiques range from theoretical discussions of the nature of engagement (or lack of incentives to so engage), to empirical research findings showing that engagement is feeble, symbolic, or makes little difference to corporate behavior or performance. The UK Kingman Review, which was commissioned to examine the role of the Financial Reporting Council (FRC), also levied critique at the Stewardship Code, stating

A fundamental shift in approach is needed to ensure that the revised Stewardship Code more clearly differentiates excellence in stewardship. It should focus on outcomes and effectiveness, not on policy statements. If this cannot be achieved, and the Code remains simply a driver of boilerplate reporting, serious consideration should be given to its abolition.

The FRC issued a majorly revised Stewardship Code in 2020. The UK Stewardship Code 2020 (“The Stewardship Code”) seems to be a product of tacit acknowledgment that the earlier normification of shareholder engagement needs to be refined. As the Stewardship Code 2020 has taken a markedly different approach from previous iterations, the investment management community may not be entirely certain what signals are being sent to them regarding the expectations of stewardship. This article argues that the earlier normification of shareholder engagement reflects a relatively narrow understanding of stewardship. This seems to be giving way to an acceptance of a variety of investment management practices that can also deliver good stewardship. In this manner, regulators and policymakers seem to be moving away from their earlier fixation upon the normification of shareholder engagement.

The UK Stewardship Code 2020 may be regarded as returning to a point of re-setting normification. This move has nevertheless been criticized as a weakening of the Stewardship Code. This paper, however, takes a different perspective, and regards the Stewardship Code 2020 as providing for a more holistic platform for norms of investment management conduct to be developed and scrutinized. The Stewardship Code 2020 is poised to facilitate discourse for a richer slate of eventual normification in investment management practices from its starting point as soft law. The meta-governance provided by soft law can give rise to ripples of discourse and change in various aspects of investment management conduct and through the investment chain. Further, we see the Stewardship Code 2020 as being poised to facilitate discourse that encompasses the range of private, contractual interests as well as social interests and regulatory objectives.

Finally, normification in investment management is far from being relaxed, although the new Stewardship Code takes a more flexible and expansive view of investment management practices as stewardship. This is because the Code is increasingly clearer on the purpose of investment management, articulating public interest objectives to be internalized within investment management mandates. The articulation of public interest objectives in investment management has also been significantly ramped up in the area of sustainable finance, hence this area of reform may provide a significant impetus for the increasing framing of investment management within public interest terms. Arguably the EU has provided regulatory leadership in this area, and the article discusses the EU’s and UK’s reforms in sustainable finance and the potential such regulatory initiatives may have for more purposefully re-orienting investment management practices.

Section A discusses the initial development of institutional shareholder engagement as a norm in investment management stewardship. This Section discusses the context and explores the unreconciled and sometimes contesting narratives that underlie the expectations of shareholder engagement by institutions. The nature of such unreconciled and contesting narratives has arguably given rise to vagueness and dissatisfaction regarding the characterization and conceptualization of engagement behavior. In unpacking these narratives, the Section shows that assertions that stewardship is sub-optimally carried out may be founded on certain assumptions or preferred narratives, without taking into account the rich context of unreconciled and contesting discourse.

Section B explores the Stewardship Code 2020 as a platform to reset the normification of investment management behavior. It argues that the Code should be appreciated against the broader context of governance concerns surrounding the conduct of investment management more broadly. These include (a) market failure findings with regard to relations within the investment chain in the Financial Conduct Authority (FCA)’s Asset Management Market Study; and (b) policy-makers’ expectations of the allocative roles of investment managers and funds in relation to economy and market-building, particularly in long-term, sustainable, and developmental finance. This Section argues that the Stewardship Code 2020 articulates certain wider and socially-facing expectations in relation to investment purpose, although it provides only general guidance as to the contractual governance within the investment chain toward these purposes. Although the Code is soft law, it provides a meta-level governance as a starting point to signal policy steering. There is nevertheless potential to influence private implementation and transform investment management practices according to purpose-based norms.

Section C then turns to the governance initiatives for sustainable finance and how these further shape new normification in investment management stewardship. The EU has introduced new Regulations for sustainable finance, and the UK will introduce its own version of regulation for sustainable finance. The EU sustainable finance reforms may go further in re-orienting investment management conduct according to the expectations of “double materiality.” Double materiality refers to the importance of attaining sustainable, non-financial outcomes as such and not merely tied to financial outcomes in investment management. We examine whether there is a clear purpose-based pivot in investment management regulation and what this achieves in relation to normification for investment management, or shareholder engagement. This Section reflects on how the articulation of public interest purpose and the regulation of investment management conduct may be taken forward in the future. Section D concludes.

A. The ‘Normification’ of Institutional Shareholder Engagement and the Narratives that Led to its Re-setting.

In the wake of the global financial crisis of 2007 through 2009, which also saw the near-failure of two large listed banks in the UK (the Royal Bank of Scotland and Halifax Bank of Scotland), institutional shareholders were accused of being “asleep,” being too uncritical of risky business practices in their investee banks, and neglecting to monitor Board risk management. The Walker Review on corporate governance in banks and financial institutions took the view that such institutional shareholder apathy provided a tolerant context for misjudgments of risk made at the Board level of the failed UK banks. The UK banking and global financial crisis provided an opportunity for reflections upon corporate and investment culture, and the role of institutional investors in fostering general economic and social well-being. Against this context, stewardship was articulated and developed to characterise in particular, the role of institutional investment. In 2010, the FRC reframed the Principles of Responsibilities of the Institutional Shareholders Committee to introduce a Stewardship Code for institutional shareholders on a comply-or-explain basis. The first Stewardship Code contained seven principles that revolved around institutions having policies and implementing engagement with their investee companies, including voting, informal engagement, escalation of engagement, and collective engagement. Institutions also needed to disclose how they managed conflicts of interest in carrying out their engagement roles.

The normification of shareholder engagement by institutions is arguably a result of crystallizing blame upon the state of institutional shareholder behavior which had already been subject to criticism prior to the events of the global financial crisis. It has been observed that institutional shareholder holding periods have declined over the years. This is largely due to trading becoming a focus for asset management, as trading gains are more easily exploited and quicker to achieve than investing for longer term capital growth. Although dispersed ownership structures naturally entail shareholder apathy, as was pointed out decades ago in Berle and Means’ original work, it was not until the 1970s and the rise of law and economic scholarship in corporate governance that the lack of shareholder monitoring in dispersed ownership companies was articulated as a distinct problem, in particular, reinforcing the agency problem of the unmonitored corporate management. In the 1990s, Useem’s, Hawley and Williams’ theses of universal owners and fiduciary capitalism reignited hope in pension funds and pooled entities that invest on behalf of the saving public, that they would monitor corporations on behalf of the broad public interest. This vision did not come to pass as empirical evidence, but continued to reflect shareholder apathy, low voting turnout, and institutions’ focus on trading on financial instrument markets to generate returns. The latter phenomenon has been termed investor “short-termism,” a malaise that entails certain adverse effects for companies responding to the needs of maintaining short-term share price levels. Corporate executives have also tended to bend towards market short-termism, bringing about corporate short-termism as their remuneration packages are usually tied to stock performance. Developments in corporate short-termism include the rise of frequent share buybacks and a shift from investment in long-term research and development to short-term goals with quicker payoffs.

The confluence of the long-running observation of sub-optimal institutional shareholder behavior and the global financial crisis from 2007 to 2009 brought about policy reform targeted at such behavior; although some commentators argue that corporate governance reforms should not be the mainstay of post-crisis solutions, nor would increased shareholder engagement be salutary for the specific issue of corporate risk-taking. Nevertheless, The Kay Review articulated that, in 2012, a need of economic recovery post-crisis was institutional shareholder engagement with their investee companies for the purpose of securing a long-term, well-performing corporate economy.

The Kay Review concluded that institutions were undertaking short-termist investment strategies that would ultimately affect the long-term well-being of the corporate sector, to serve social and economic good. In this manner, The Kay Review framed market and corporate short-termism as malaises pitted against the optimal goal of long-termism and recommended that changes in institutional ownership behavior were key to reversing the unhealthy trend. In particular, The Kay Review recommended that institutional shareholders should be more engaged in monitoring their investee companies for long-term economic well-being, which is in the public interest, and such engagement should be of a type that is specific and involves strategic and governance matters at companies. The Kay Review suggested that such behavior could be incentivized, in terms of lowering the barriers and costs to collective engagement, as well as potentially legalized, in terms of reviewing the fiduciary law that governs investment management. Finally, institutions should emulate Warren Buffett’s investment ethos of more concentrated holdings in smaller numbers of companies in order to monitor and engage effectively. Hence, the specific form of shareholder engagement was endorsed. This form of shareholder engagement envisages that institutional shareholders should go alongside in order to monitor corporate management, raise critical questions, and exert a benign influence. Issuer-specific engagement has arguably become the optimal norm in institutional shareholder behaviour, as reinforced in the Stewardship Code 2012.

These developments in the UK did not go unnoticed in the EU, where policy-makers were also convinced that institutional shareholders needed to change their behaviour to support the long-term recovery and the general well-being of the corporate economy in the EU after the global financial crisis. Shareholder engagement came close to being mandated in the Shareholders’ Rights Directive 2017. The Directive introduced increased shareholder powers to reinforce and support their monitoring role, such as in relation to executive remuneration policies and related-party transactions. In particular, institutional shareholders, i.e., both asset owners and managers, need to institute an engagement policy and provide an explanation if they choose not to do so. The implementation of the engagement policy relates to long-termism and includes non-financial concerns such as environmental, social, and governance issues relating to investee companies. Further, long-termism is itself adopted as the optimal investment management horizon as asset owners and managers need to report on how their investment strategies and mandates meet long-term objectives in equity strategies.

There is, however, chequered practice on the ground regarding issuer-specific engagement. The implementation of the Stewardship Code in the UK and shareholder engagement generally under the EU Directive were criticized in many quarters. In the next Section, the key critiques are surveyed, and we argue that these critiques are based on unresolved contests of narratives surrounding the norm of shareholder engagement. Shareholder engagement is essentially a means to a purpose or for certain outcomes, not an end in itself. The lack of clarity surrounding the purpose of shareholder engagement has created debates on many sides as to what shareholder engagement ought to be for. The lack of resolution of such debates has left all sides disappointed with the state of implementation of shareholder engagement. Hence, regulators and policy-makers need to step back from the fixation upon the issuer-specific engagement and engage with the normative debates regarding expectations of the investment management industry. The following unpacks the contesting narratives and expectations surrounding shareholder engagement to explain why disappointment has been felt on many sides leading to the resetting of the Stewardship Code 2020..

1. Contesting Narratives for the Norm of Issuer-specific Shareholder Engagement

The policy discourse surrounding the encouragement towards “long-termist” investment management behaviour seems to underlie the first iterations of the UK Stewardship Code. The critique against investor and corporate short-termism underpinned the call to shareholder engagement. In this manner, shareholder engagement is arguably synonymous with holding for the long-term and exercising voice instead of exit regarding particular investee companies. Yet, this call to optimal investment management conduct using voice is an over-simplification as it cannot be assumed that investment management mandates are homogenous. Even the Kay Review acknowledges that investment managers carry out a range of mandates and states that “[n]ot all investors have long holding periods in mind: nor, necessarily, should they. An activist investor who seeks changes in strategy or management may anticipate that the effects of those actions on the share price will be felt in a short period and plan an early sale.” Although the Kay Review is of the view that a majority of traders rather than long-term investors present in UK equity markets would have a marked adverse effect upon corporations in the long-run, the variety of investment management mandates existing as private arrangements cannot be completely disavowed.

Indeed Pacces, in his critique of the European Shareholders’ Rights Directive that favors shareholder engagement for long-termist objectives, argues that whether long-termism is optimal or efficient for a company or otherwise is not susceptible of a standard answer. The question is whether what companies decide to forgo in terms of long-term thinking is wrongly priced and undervalued in markets. For some companies, adopting a near-term strategic change (such as being agitated by an activist hedge fund) could be efficient, as consequences of this change could lead to an efficient, immediate adjustment in market pricing. While for others, such a strategic change may be a worse trade-off for a long-term decision whose payoffs arrive much later, especially if markets misprice and excessively discount the ultimate payoffs of a long-term decision. But, in light of literature in behavioral economics that highlights the tendency in markets towards under-pricing, and hence mis-pricing, of long-term benefits, can it not be argued that the legislative endorsement of long-termism as a preferred purpose for investment management serves to correct market failure? This market failure also entails social consequences as many ordinary savers and pensioners depend on the long-term financial health of the corporate economy to meet their needs. Nevertheless, it can be counter-argued that mandating long-termism by regulatory fiat is over-inclusive, as this treads upon the freedom for investment management mandates as private arrangements. As both the UK Stewardship Code and the EU Shareholders’ Rights Directive provide a comply-or-explain framework for institutions regarding policies on shareholder engagement, it can be argued that even the long-termism purpose is not hardened in law. In this manner, the policy encouragement towards issuer-specific engagement should be clarified based on compatibility with institutions’ investment time horizons.

But, it may be argued that policy-makers, though not explicit, have been implicitly encouraging long-termism as being compatible with wider social good. Hence, the expectations of stewardship reflect a contest between the perception of investment management as a private mandate fulfilled for contractual purposes and the perception that it should perform as a force for public or social interest in the macro landscape of a healthy and well-performing corporate economy in the long-term. The private-public contesting narrative can also be framed in another way: the perspective that investment management serves the interests of those in the saving relationship and investment chain, hence the exercise of corporate governance roles is a facet of this; versus the perspective that investment management serves corporate governance roles and plays a part in holistically nurturing the investee company and more broadly the corporate economy. The latter is arguably not well-conceived by the investment management community, who perceive their enjoyment of shareholder rights and powers but not necessarily duties and responsibilities to the company they invest in.

Although Katelouzou characterises the normification of shareholder stewardship, or engagement, as a Polanyian moment, where institutions’ shareholder roles are not atomistically carried out for merely private purposes but cognizant of a broader social agenda of gatekeeping the health and optimal conduct of the corporate economy, Talbot is more pessimistic. She argues shareholder stewardship or engagement is borne out of private incentives, and this financialized lever, in the absence of clearer embedment of societal expectations and norms into investment management conduct, would only be used for the self-interest of the investment management industry. The contest of private-public narratives underlying the preference for long-termism and the purpose of shareholder engagement is arguably unresolved.

Further, there are indications that policy-makers also see shareholder engagement as a channel to address issues of corporate behavior and implications for wider society, i.e., the EU Directive’s reference to non-financial considerations such as environmental, social, and governance (ESG) concerns, which connect shareholder engagement to a form of gatekeeping towards broader social good or mitigation of social harm. Although the engagement provisions in the Directive are “comply-or-explain” in nature, the expectations surrounding issuer-specific shareholder engagement raise questions regarding reconciliation between the private law of the fiduciary nature of investment management and the more socially-facing role that institutions are expected to assume. Case law in the UK has clearly supported investment managers discharging their legal duties based on conduct focused on generating financial returns. However, the United Nations Environmental Programme’s report has clarified that modern fiduciary duty in investment management should encompass consideration of ESG issues where material or where mandated. This may not extend more generally to ESG issues that matter for wider social good without a clear connection with investment performance. In sum, underlying contesting narratives framing the roles and purposes of shareholder engagement make it highly challenging for institutions to satisfy their critics regarding their implementation of stewardship. We turn to specific and well-articulated criticisms against institutions and show how these are deeply steeped in the contesting narratives.

2. The Criticism against Institutions for Formalistic/Symbolic Engagement

Institutions’ shareholder stewardship roles have often been criticized as formalistic and symbolic, lacking real substance in terms of outcomes, as mentioned in the Kingman review. However, in the context of the unresolved contesting narratives as to what stewardship is for, can institutions rightly be criticized for performing a form of stewardship, largely manifested in terms of having policies for engagement and voting?

Institutions that signed up to the earlier Stewardship Codes were asked to disclose their policies for stewardship. Hence, having a policy is treated as a proxy for the performance of stewardship. The FRC’s evaluation of institutions’ compliance with the Code was based on the text of their stewardship policies only, but this inevitably left a sense of vacuum as to discerning what institutions have actually achieved. Further, stewardship policies could be written in a boilerplate and meaningless manner. This prompted the FRC to introduce a “tiering regime” in 2016 to rank institutions concerning their disclosure quality. The tiering reform at least pushed institutions towards a more meaningful articulation of their policies.

What has attracted criticism to institutions’ stewardship practices is this sense of vacuum in terms of connecting policy to outcomes, or the lack of demonstration the different policies have made. Stewardship achievements can only be meaningfully evaluated against expected purposes and outcomes. Empirical research shows that institutional stewardship activities have little or no impact on companies’ operating performance. But is this the yardstick against which we ought to measure stewardship efficacy? Empirical research has also shown that institutional stewardship activities reduce in audit costs for companies, suggesting that auditors perceive benefits in terms of institutional monitoring and efficacy. But is the achievement of “substitute” gatekeeping between external audit and shareholder monitoring the yardstick for evaluating what stewardship or engagement achieves?

For example, if one looks at the critique levied against institutions for the exercise of their “say on pay” rights, there is significant critique against the ineffectiveness of say on pay, as executive remuneration levels are not perceived empirically to be under control, and pay conditions in the UK or United States have not become more egalitarian. But it needs to be questioned what say on pay is exercised for. If shareholders are tasked with gatekeeping pay moderation at executive levels and playing a part in addressing distributive inequalities in society, then this purpose is not articulated as such in the legislative conferment of say on pay to shareholders. More radical transformation of institutions’ shareholder behavior would have to be shaped by institutional change. Hence, can institutions regard themselves as only narrowly assessing whether pay levels are appropriate to the performance of the portfolio company before them?

Davies pointed out that the U.K.’s Stewardship Code is more procedural than substantive in nature, as what is written in the policies for engagement and voting, and how these are implemented, are up to institutions to determine. Unless the law is unambiguous about what engagement or stewardship should seek to achieve, especially in measurable terms, institutions must default to a stewardship purpose that is consistent with their objectives defined by (a) the legal framing of investment management conduct, and (b) the contractual framing of their investment management mandates. In this manner, it can be argued that the Code’s, as well as the Directive’s, provision for institutions having policies, but not prescribing further, would mean that there is no other top-down purpose for stewardship that changes the objectives for investment management conduct. Institutions’ engagement and stewardship roles therefore do not depart from the purpose of serving ultimate savers’ needs within the framework for investment management conduct in fiduciary and contractual law.

We need to ask why policy-makers and regulators strongly encourage issuer-specific shareholder engagement as an optimal manner of investment management conduct. Whether shareholder engagement is optimal for carrying out institutions’ investment mandates would surely have to be evaluated on a case-by-case basis taking into account the nature and purpose of the mandate and agreed strategies of investment. This is also linked to the critique made against “untailored” forms of stewardship as opposed to issuer-specific engagement, as there seems to be an assumption made by policy-makers and commentators that the latter is superior.

The fiduciary framing of investment management conduct provides for its legal parameters, chiefly in relation to duties focused on securing financial returns for beneficiaries, in a manner that is loyal and with diligence and care. The fiduciary framing in the United States is more expansive than in the U.K. and commentators argue that investment objectives can be subject to more organic development. Nevertheless, the upshot is that investment purpose or objectives are privately determined. Although U.S. law provides much clearer articulation of the connection between institutions’ corporate governance roles and their fiduciary governance, as pension fund institutions are required to vote the shares they hold in portfolio companies, this regulatory fiat deals with a mandatory means of investment management and not its ends. It would also be clear that voting as a prescribed means says nothing about how to vote, as that would be in the freedom of institutions to designate. In the eyes of the regulator, adhering to these methods reflects meaningful management of the portfolio and of diligence. The regulatory mandate to vote can be seen as supportive of institutions’ investment management conduct and their accountability to their beneficiaries. Such an underlying narrative is one that focuses on stewardship as serving the private purposes of the investment management mandate.

For the U.K. and EU, it is questioned to what extent an alternative purpose for engagement implicitly lurks in its underlying narrative. As argued above, the purpose of “long-termism” is part of a “comply-or-explain” regime in the Directive, and not all institutions are managing funds according to a long investment horizon. The objectification of “long-termism” can therefore only mean the long-term well-being and performance of investee companies. In the U.K. and EU, the underlying narrative arguably frames institutions into a gatekeeping role to safeguard the long-term well-being of the corporate sector as a social good. This is a much more public interest-oriented objective external to and not derived from the private paradigm of fiduciary investment management. Such an objective can only transform investment management conduct if it is legalized unambiguously, therefore allowing the clear framing of engagement as a norm that is part of institutions’ corporate governance roles, as owed to portfolio companies. Such a development is not discerned in U.K. or EU company law developments. It is, however, arguable that both the U.K. and EU have now taken steps now to address the clearer articulation of investment management objectives, therefore shaping the regulatory governance of institutions’ conduct of investment management according to more public interest expectations. These are canvassed in Sections B and C.

3. Criticism Against Institutions in relation to Lack of Issuer-specific Stewardship

An oft-raised critique against the manner of shareholder stewardship or engagement is that some institutions do not engage in issuer-specific monitoring and hence do not fulfil intelligent gatekeeping roles for each of their portfolio companies. These institutions in particular offer passive investment management strategies based on curating portfolios that match an established index. Passive investment managers tend to show interest, particularly in voting, in “across-the-board” issues such as best practice in corporate governance or ESG issues for portfolio companies without much discrimination. This is regarded as sub-optimal compared to issuer-specific engagement such as conducted by activist hedge funds, as well as certain socially responsible themed funds. The latter have the mandate to engage with ESG issues, such as by filing shareholder proposals or engaging in informal dialogue with companies.

But why should passive investment strategies such as exclusion or untailored stewardship be regarded as sub-optimal from the point of view of fiduciary investment management? Or divestment in the case of actively managed funds?

Despite Bebchuk and Hirst’s pessimistic account of passive investment managers’ disengagement from their corporate governance roles, there is evidence to the usefulness of passive investment managers’ techniques. This should be considered carefully by policy-makers as the shift of assets under management from active to passive is marked, and the “Big Three”, Blackrock, Vanguard, and State Street, would come to assume importance in corporate governance discussions. Commentators argue that passive investment funds vote intelligently in face of hedge fund activism, showing that they provide a moderating gatekeeping influence even if they do not initiate actions. It is also to be noted that active managers who stock-pick are not likelier to adopt issuer-specific shareholder engagement as part of their optimal investment management strategy.

Several commentators find that passive investment managers exert considerable influence in relation to issue-specific matters, not necessarily issuer-specific concerns. These matters relate generally to corporate governance practices, shareholder power and rights, and increasingly ESG issues. Such influence is usually exercised by voting, which on the one hand may be regarded as visible and low cost, but on the other hand is still a definitive exercise of shareholder power. The Big Three are also not susceptible to merely voting according to proxy advisers’ recommendations. In this sense, Gordon has forcefully argued that passive investment managers can be positioned as optimal gatekeepers for portfolio systematic risk, relating to issues that affect the corporate economy as a whole, such as ESG issues, rather than idiosyncratic risk associated with individual portfolio companies. Griffith also argues similarly that mutual funds’ corporate governance roles lie in voting for proposals of common interest for the saver constituency. In this manner, the corporate governance roles of passive investment managers can be looked at differently in terms of what they achieve within their investment management strategies and mandates and not be judged by a narrow yardstick focused on the expression of issuer-specific engagement.

Further, divestment actions by actively managed funds would seem contrary to issuer-specific engagement aimed at changing corporate behavior. But such actions directed at certain types of portfolio companies, such as those engaged in traditional energy activities like fossil fuels, is often expected and perceived as supporting the public interest and actually called upon by the public. Although divestment is not in the vein of issuer-specific engagement seeking to change corporate behavior, it may achieve beneficiaries’ objectives as well as resonate with public interest. Given that much of the socially responsible investment universe adopts exclusion strategies, why should exclusion or exit be regarded as less important than issuer-specific engagement?

It is arguable that the preference for issuer-specific engagement being the norm for shareholder engagement must be based on an underlying narrative that seeks to enhance institutions’ corporate governance roles in the belief that their monitoring benefits portfolio companies in the long-term. Such a preference cannot be based on a narrative that is focused only on the investment management dimension, i.e. premised on institutions performing optimally for their ultimate savers. The narrative supporting institutions’ private roles to deliver for their savers would accommodate greater freedom in designing the various means in investment management conduct for meeting beneficiaries’ objectives and would unlikely be fixated upon issuer-specific engagement. In this manner, the encouragement towards issuer-specific engagement is arguably beyond the fiduciary and contractual framing of institutions’ obligations.

Indeed, this may explain why policy-makers do not regard the “normification” of issuer-specific shareholder engagement as legitimising hedge fund activism, as there is inconclusive evidence regarding the long-term performance effects upon target companies. Empirical research has found continuing benign performance effects in a sample of companies targeted by hedge funds in the UK for up to five years. But corporate performance has also been adversely affected by hedge fund activism. Issuer-specific engagement by hedge funds does not sit easily with the policy preference for corporate long-termism although such a form of engagement is possibly the most intense and well-informed type in the market for corporate influence. This author has also earlier discussed a type of shareholder engagement undertaken by some mainstream investment managers as part of their focused investment management strategy. This strategy targets underperforming companies in a focused manner in order to improve performance and shareholder value in due course. Such a strategy is likely less aggressive than hedge fund activism and has been lauded to be constructive for companies in the long-term. It is, however, a type of investment strategy and it can be questioned whether all equity strategies should be in the same mould.

4. Criticism Against Institutions in Relation to Incentive-based Limitations to Stewardship

Next, institutions may be criticized for ineffective engagement or stewardship because they lack incentives to do so, not because their investment strategies are carefully considered and incompatible with issuer-specific engagement. A number of commentators argue that institutions’ incentives to engage in stewardship is determined by private factors within the chain of investment management relationships, such as how pension consultants influence pension funds as asset owners and how such influence plays out in the delegation to asset managers, and other service providers in the investment chain. Hence, institutional shareholders are incentivized to behave as “agency capitalists” rather than Hawley & Williams’ “fiduciary capitalists.” In particular, short-term (such as quarterly) evaluations of asset managers by asset owners, intense competition in the asset management market, and chain intermediaries who tend to maximize their own interests by rent extraction are all phenomena that affect investment management behavior. The non-assumption of effective shareholder engagement can thus be perceived to be a market failure. In this manner, it can be argued that the reason for institutions falling short of issuer-specific shareholder engagement is not due to the ambiguities and inappropriateness surrounding such normification, but rather due to institutions’ structural weaknesses.

In order to overcome institutions’ lack of incentives to engage in shareholder stewardship, the Kay Review has opined that facilitating collective engagement, so that the cost of stewardship can be reduced and shared, would be important. This has empirically been observed to be beneficial for institutions in a few jurisdictions who would otherwise put off engagement due to perceived cost. However, the UK Investors Forum does not seem to be well-used. It records only forty engagements with listed company boards to date.

One of us in another work critically questioned whether perceived structural weaknesses, such as investor short-termism and disincentives for long-term shareholder engagement, are due to other legitimate drivers and rationale, such as the regulatory framework for investment funds. The regulatory framework for investment funds revolves around regular and periodic reporting of performance, to mitigate the perceived principal-agent problems inherent in the design of pooled and collective investing. Hence pension funds, albeit being long-term in horizon, are subject to regular reporting, and defined benefit funds subject to yearly actuarial review. Mutual funds that are open-ended are regulated to protect investors by way of strong redemption rights, regular valuation and reporting are required to support these regulatory objectives.

Regular accountability and reporting entail certain consequences. The insistence of regulatory frameworks on regular evaluation and accountability exacerbates the short-termist preferences in investment management because such evaluation and accountability, pursuant to the need of being standardized and objective, is necessarily based on market price, therefore reinforcing a narrow-minded attention to marketized values. Regular reporting also forces funds to regularly evaluate their performance, and funds may be under pressure to boost such performance from one reporting interval to the next. For open-ended investment schemes, past performance may also be crucial to attracting new inflows.

The regulatory regime for regular reporting has played no small part in encouraging funds and their asset managers to pursue short-termist investment performance. Guyatt argues that investor myopia is entrenched, as it is seen as a defensible practice considering regulatory requirements. Funds and asset managers are reluctant to move away from the norm and adopt ‘outlier’ modes of investment thinking that do not strictly conform to the dominant practice of short-termist evaluation.

In this manner, institutions may be disincentivized from issuer-specific shareholder engagement because of competing legal imperatives that pull in different directions. The matter may not be simply framed as a market failure on institutions’ part. It can be argued that resolving the ‘normification’ of issuer-specific shareholder engagement requires a wider institutional apparatus, addressing the competing regulatory demands placed on institutional investors and the contest between the private and public expectations of what shareholder engagement is for.

Fixation upon issuer-specific engagement has resulted in an unproductive cycle of criticisms against institutions that are narrowly focused. It is, however, arguable that policy-makers are finally ‘out of the woods’ as steps have been taken to articulate more clearly the desired purposes of investment management in law and soft law. These developments would enrich the private investment management dimension by adding public interest impetus for governing investment managers. In this light, a more comprehensive rubric of policy measures is being developed, away from the singular fixation on issuer-specific shareholder engagement.

The UK Stewardship Code 2020, adopting an apply-and-explain modus for voluntary signatories, contains goal-based articulations in relation to long-termism, market-wide stability, and ESG objectives. It is poised to reset the governance of investment management conduct with purpose-based steering. A clearer imperative is also found in the EU’s sustainable finance regulations, as sustainability disclosure and stewardship obligations are now introduced.

The next Section proceeds to discuss the UK Stewardship Code 2020, to analyse the beginnings of purpose-based articulation for investment management conduct, as well as to offer suggestions as to how institutions should respond to the initiative.

B. Stewardship Code 2020

The UK Stewardship Code was revised in 2020 from its 2012 version, in light of the Kingman Review’s critique against the lack of demonstration of ‘outcomes’ by signatories adopting the Code. The Stewardship Code 2012 contained seven principles which all revolved around issuer-specific shareholder engagement and forms of engagement that were encouraged, i.e. having an engagement policy (Principle 1), informal dialogue with portfolio companies (Principle 3), escalation of engagement (Principle 4), collective engagement (Principle 5), and voting (Principle 6). Principles 2 and 7 dealt with institutions having a conflict-of-interest management policy and accountability to their beneficiaries respectively.

The 2012 Code was for voluntary adoption and signatories needed to ‘comply or explain’. Where signatories deviated from any of the Principles, an explanation for such decision had to be provided. Many asset managers signed up to the Code, as being a signatory could be attractive to asset owners looking to delegate portfolio management. However, over the years, the FRC found that signatories made boilerplate disclosures of policies and explanations, and the ‘stewardship’ label could be eroded in terms of quality for market confidence. In 2016, the FRC introduced a tiering regime to rank the quality of signatories’ disclosure. Nevertheless, the quality signals sent by the FRC were entirely based on what signatories said about their stewardship activities. These were not further mapped against what they did, as stewardship reporting was not required to be assured. Hence, both the FCA and the market could not tell for certain what has been achieved in terms of improvement or transformation of corporate behavior.

The 2020 Stewardship Code is an attempt to address the limitations of the previous Code by introducing a set of twelve new principles for asset owners and managers, and a set of six new principles for service providers. The Code also adopts a new ‘apply and explain’ regime for signatories. An ‘apply and explain’ regime may transcend the limitations of disclosure under a ‘comply or explain’ regime. In the latter regime, ‘explain’ is regarded as the antithesis to ‘comply’. Hence, institutions who regard themselves as broadly ‘compliant’ would likely say little as the narrative in explain is treated as an alternative mode of action. ‘Comply or explain’ based disclosure requirements therefore do not encourage knowledge-building about what institutions do. In contrast, apply and explain is premised on the basis that application of the Code’s principles is mandatory for signatories, and ‘explain’ is meant to flesh out how the application takes place. Explain is therefore no longer optional or is regarded as ‘fringe’ action but is expected and purposed towards knowledge-building of what institutions do. In this manner, the FRC’s adoption of apply and explain is a direct response to the Kingman Review’s critique that outcomes of stewardship remained shrouded in mystery.

Asplund also argues that the apply and explain approach, which was first adopted for the South African Corporate Governance Code (King Code IV), is rooted in wider stakeholder and social interest in the governance of listed companies in South Africa. The Code adopts the goal of long-term sustainability for the South African corporate economy, and in this manner, apply and explain is meant as a form of information accountability more broadly to stakeholders and wider civil society, so that all can scrutinize how listed companies are governed and managed. It is arguable that this foundation for the ‘apply and explain’ nature of the King IV Code can apply to the UK Stewardship Code 2020. This is because the Code has now, as argued below, articulated more clearly goals and purposes for institutions that are wider-facing in nature, beyond the private universe of their investment management chains and accountability. Hence, the explain aspect of adherence to the Code can be regarded as knowledge-building for the benefit of policy-makers, regulators, interested stakeholders, and civil society who may scrutinize the modus and arrangements of investment management in order to interrogate their social effects. Broad-based interest in global asset management is likely to take off as civil society increasingly recognizes the phenomenal amounts of sovereign, household, and investment assets that are managed by global asset managers.

The FRC, in its first survey of asset owner and manager signatories’ reports under the apply and explain approach, finds encouraging signs of disclosure by signatories who understand that the explain approach requires them to shed light on what they do. The survey also extracts good explanatory practices as examples to encourage other signatories.

This paper argues that there are four key aspects to transformative behavior for institutions provided in the Code. These aspects reflect the trend of increased governance endeavor on the part of policy-makers vis-a-vis institutions’ investment management conduct, usually thought to be a discretionary universe subject to private contractual design and governed only by the private law of investment management. Even if the Code is regarded as soft law and not in the same manner as legislative rules, the Code signals an emerging governance initiative. This initiative should also be understood against a broader context of developments in increased regulatory governance of investment management conduct introduced in the EU and UK. These regulatory initiatives have resulted from the Financial Conduct Authority’s Asset Management Market Study and the recent developments in the EU’s sustainable finance regulations.

The four key aspects are:

(a) Articulation of wider public interest purposes of stewardship (Principles 1, 2, 4, 6, and 7) in the Code;

(b) Moving away from exclusively normifying shareholder engagement as equivalent to stewardship but adopting a wider understanding of investment management conduct and strategies in achieving the purposes in (a) (Principles 2, 3, 5, and 12);

(c) Continuing support for shareholder engagement but requiring disclosure of what such engagement seeks to achieve and its efficacy (Principles 9, 10, 11, 12, also 5 more broadly); and

(d) Cognizance and reporting of investment chain monitoring and activities, possibly for knowledge-building in relation to agency problems (Principle 8, Principles 1-6 for service providers).

1. Articulation of Wider Public Interest Purposes of Stewardship (Principles 1, 2, 4, 6 and 7)

The Code now articulates several purpose-based goals for stewardship more clearly than under the previous Code. This goes an extent towards addressing the previous critiques levied against stewardship. Stewardship processes or activities can now be evaluated against particular goals, which have been debatable and implicit surrounding the previous Codes. The move to articulating purposes and goals for investment management may be regarded as a radical ‘governance’ measure. The regulation of investment management has primarily been focused on the intermediary-client relationship, in order to mitigate principal-agent problems, in the regimes in the US and United Kingdom/European Union. Regulation is focused on the pre-sale context, in terms of advice and product disclosure, but the universe of post-sale investment management conduct and outcomes is largely left to the working of private market forces subject to certain investor protection rights which relate more to exit than voice. In this manner, articulating what investment management is for can be regarded as radical and potentially transformative.

The Code’s purpose-based articulations complement recent regulatory reforms. In the FCA’s recent reforms for pension funds, whether defined benefit or contribution schemes, funds need to set out investment objectives with their asset managers. This may be regarded partly as a response to principal-agent problems, as expert asset managers and pension consultants can appear to wield significant influence over less expert pension scheme trustees and governance boards. However, the regulatory mandate to specify and clarify purpose also engages with social accountability more widely to the advantage of beneficiaries, and allows regulators and policy-makers to scrutinize how funds conceive of their purposes and what these are. This is especially relevant in light of policy-makers’ interest in mobilizing the private sector, particularly private assets under management, towards purposes that are aligned with public interest, such as sustainability goals and social development in impact investing.

Principle 1 now defines stewardship as delivering long-term value for clients and beneficiaries and sustainable benefits for the economy, society, and environment. This Principle is inherited from the previous Code that articulates long-termism as a preferred goal; but with its roots being nested in a ‘comply or explain’ regime, it is arguable that long-termism could be regarded as a strong, but not binding, steer. With the ‘apply and explain’ regime, the goal of long-termism is not optional. But, as asset owners and managers can elect to be signatories, those who do not identify with long-termism could choose not to be signatories. Mainstream institutions, especially with pension and mutual fund portfolios, may be faced with demand-side pressure to opt in, which means subscribing to the investment purpose of long-termism.

In an ‘apply and explain’ regime, mainstream institutions opting into the Code would have to explain how they manage investments for long-term value creation, as opposed to short-term performance. In this sense, it is queried if active management strategies would be reshaped by the long-termism goal, and perhaps their churning tendencies may be moderated. The long-termism purpose articulated here is arguably inherently biased against trading strategies, but these are neither necessarily inefficient nor mispriced. Securities mispricing is due to behavioral sub-optimalities, information inefficiencies, and structural conditions of markets that promote the qualities underlying mispricing. For example, allowing high frequency traders’ servers to be co-located with stock exchange servers brings about a structural advantage for traders in exploiting a short window of information inefficiency. Trading itself is merely an information signal to the market that allows for price adjustment. At the macro level, one needs to ask whether it is trading frequencies and efficiencies that have contributed more to price bubbles or whether other drivers such as central bank liquidity tools contribute more to such phenomena. It remains uncertain if investment intermediaries explaining their long-termist strategies need to show moderation of trading behavior, or otherwise. Nevertheless, the opportunity to explain can afford investment intermediaries the space to account for broader structural factors affecting trading behavior. Signatory reporting is, however, not assured and continues to be susceptible to self-selectivity, so it remains highly uncertain how precise a light stewardship reports would shed on investment managers’ interpretation of long-termism and the proxy indicators for adhering to this goal.

Principle 1 can also be regarded as encouraging investment value creation to be holistic and aligned with sustainable benefits for the economy, society, and the environment. The outward-facing purposes for investment management are not only found in this Principle, but also continue through Principles 4 and 7 where these purposes are more clearly defined. Principle 4 relates to institutions’ roles in promoting a well-functioning financial system and not contributing to market-wide systemic risk, while Principle 7 relates to integrating material ESG issues and climate change targets.

Systemic risk in the financial system is defined in relation to the preservation of the functioning of the financial system in a manner that does not result in domino-type failures of connected institutions or disruption to key services that may not be substitutable. Does Principle 4 mean that institutions should identify and manage these risks, ensuring that they do not contribute to these? In this manner, institutions should integrate systems that mitigate trading disruptions for clients and markets or counterparty risk. There is an existing regulatory requirement for investment intermediaries engaged in high frequency algorithmic trading to mitigate the possibility of systemic risk creation. This MiFID requirement ensures that where algorithmic high frequency traders become key suppliers of market liquidity in particular financial instruments, they continue to carry out that role under all market conditions and do not unexpectedly withdraw market liquidity, which may destabilize market prices. It is questioned if Principle 4 addresses investment intermediaries’ awareness of financial market and systemic risks in the nature described above.

The FRC seems to be unclear as to what Principle 4 imports. The oversight organization has raised an example of good practice in its survey, focusing on thematic risk in the corporate economy. The FRC’s example relates to issue-specific or systematic risk, which is addressed by Principles 9-11 as discussed below. This systemic risk analysis is arguably different from the market-wide systemic risk provided in Principle 4. The disconnect between the FRC and Principle 4’s market stability goals may be understandable, as such a goal may present as strictly within the remit of the market and prudential regulators. Nevertheless, the implementation of Principle 4 requires more clarity, arguably in relation to institutions’ risks in trading strategies, leverage employment, if any, settlement risk, market abuse risk, etc. Institutions should shed light on how they fulfil their responsibilities as citizens of the financial system and contribute to its healthy functioning.

Principle 7 relates to investment management conduct that integrates material ESG matters and climate change. The FRC tends to see such integration as primarily demonstrated by shareholder engagement. This discrepancy may be because ESG engagement is arguably consistent with the Shareholders’ Rights Directive provisions. Indeed, signatory reporting of engagement with environmental concerns is regarded well in the FRC survey, relating to purpose-based stewardship in Principle 1, or engagement activities in Principles 9-11 (discussed further below). One argument to make is that Principle 7 refers to material ESG matters, and, therefore, does not break new ground in terms of institutions’ perception of the needs for fiduciary investment management. The call to integrate material ESG does not compel institutions to demand ESG performance beyond that connected to financial value creation (albeit in the long term). However, the EU sustainable finance regulations, discussed in Section C, seem to demand more of institutions in their investment management conduct.

Finally, Principle 6 articulates the need for signatories to take into account the needs of clients and beneficiaries as a whole and communicate appropriately with them as to how stewardship meets their needs. This client- and beneficiary-based Principle is an extension from the previous Code, which requires accountability to beneficiaries on stewardship activities. But Principle 6 is different in that it goes beyond ex post accountability to require that asset managers take ex ante steps to ascertain the wishes of asset owners and beneficiaries, and consider how these considerations may be translated into investment management conduct. We regard it as a purpose-based articulation for investment management conduct to be carried out with the consciousness of investment managers’ representative capacity. In this manner, institutions need to explain how this representative capacity is implemented. The FRC disseminated generally weak reporting by signatories, as signatories are not comprehensive or consistent in terms of reporting their investor base or what is communicated to investors. Signatories’ reporting also tends to focus on processes carried out, such as surveys of client wishes, while the FRC seems to express expectations for explanation as to how institutions use this information and conceive of their representative capacity.

Arguably, Principle 6 goes further than the legal framing of rights within the investment chain. Beneficiaries are usually unable to exercise their economic interest rights due to the no-look-through rule that accords the legal registered holder of shares, usually a custodian, with corporate governance rights. It is possible for asset owners to instruct and steer asset managers, who should ensure that such communications are conveyed to the custodian, to exercise corporate governance rights; however, structural impediments and incentive weaknesses exist within the investment chain. Critiques have been levied against the dilutive effects of the investment chain upon institutions’ engagement with their corporate governance rights, prompting research into potential reform of English law on intermediated securities. If beneficiaries were empowered to feed their voice into the corporate governance processes, the corporate economy could more effectively be subject to social voice and pressure. In this manner, Principle 6 does not merely deal with mitigation of principal-agent problems in the investment chain, although that is an immediate consequence. Principle 6 appears more purpose-based, incorporating a stronger social basis for investment management conduct, and potentially has a radical impact on the principal-agent problems affecting voiceless beneficiaries. Accordingly, the FRC should require institutions to report on how more clearly they ascertain beneficiaries’ and asset owners’ wishes and perceptions in order to map out a balanced representative strategy.

2. Moving Away from Exclusively Normifying Shareholder Engagement as Equivalent to Stewardship , Adopting a Wider Understanding of Investment Management Conduct, and Strategies in Achieving the Purposes in (a) (Principles 2, 3, 5 and 12)

The Code may be interpreted as moving away from exclusively ‘normifying’ issuer-specific shareholder engagement. Engagement activities are now articulated in Principles 9-11, while the rest of the Code adopts a wider understanding of stewardship conduct. Principle 2, which requires institutions to ensure that their governance, resources, and incentives support stewardship, may be broadly interpreted to mean that institutions should disclose how their strategies meet beneficiary needs and how such strategies are resourced and capitalized within institutions’ governance and incentive structures.

In this manner, asset owners can discuss asset allocation and outsourcing strategies as meeting stewardship demands, and asset managers can discuss their choice of strategies and how these meet asset owners’ and beneficiaries’ needs. Thus, a wider range of investment management conduct and strategies can be acceptable forms of ‘stewardship’ beyond the hitherto ‘normification’ of issuer-specific shareholder engagement. Indeed, the FRC’s survey highlights institutions’ disclosures of their own governance initiatives, such as improving diversity in their own outfits, as being connected with stewardship. Such acceptance of a wide range of ‘stewardship’ activities is reinforced in Principle 12, which requires signatories to exercise their rights and responsibilities effectively. These rights and responsibilities are recognized differently across varying asset classes, including fixed income, equities, and other possible asset classes.

Following this new broad perception of what constitutes stewardship, Principle 5 requires institutions to regularly review their policies, assure their processes, and assess the effectiveness of their activities. This is buttressed by the more specific Principle 3 that deals with effective management of conflicts of interest to avoid compromising beneficiaries’ interests (inherited from the previous Code). The breadth of Principle 5 is not presumptive as to what manners of conduct count as stewardship, so long as adequate explanation of such conduct is made in Principle 2. The FRC noted in its survey that signatories tended to discuss engagement process reviews, which is possibly a path-dependent response carried over from adherence to the previous Code. Signatories have not reported satisfactorily against Principle 5 as yet, which may take time for them to realize the importance of the broader approach in order to report a wider range of review, assurance, and evaluation measures for a broader spectrum of investment strategies and conduct accommodated under Principle 2.

3. Continuing Support for Shareholder Engagement but Requiring Disclosure of What to Achieve and Its Efficacy (Principles 9, 10, 11, 12, and 5)

Principles 9, 10, and 11 arguably inherit the previous Code’s provisions on the forms of shareholder engagement regarded as desirable practice. An argument exists that, in light of the discussion in subsection (b), Principle 9 has adopted a wider conception of engagement that need not be issuer specific. Principle 9 envisages institutions may be issues-focused rather than issuer-specific, where such engagement can be delegated, and is also reflected in Principle 11 which deals with escalation of engagement activities. In the same vein, Principle 10 also accommodates a wider conception of engagement by articulating that collaborative engagement, where necessary, could be issuer-specific or thematic in nature.

Accordingly, Principles 9-11 would likely negate many previous critiques focused on non-issuer-specific engagement. But the difference between Principles 9-11 and the previous Code is that disclosure is now required not only of policies, but of implementation, processes, and outcomes achieved. Effective reporting in this area can bolster knowledge-building as to whether and to what extent shareholder engagement should itself be ‘normified.’

4. Cognisance and Reporting of Investment Chain Monitoring and Activities, Possibly for Knowledge-Building in Relation to Agency Problems (Principle 3, 8, Principles 1-6 for Service Providers)

Agency problems exist between the different links in the investment chain. Additionally, conflicts of interest exist between asset managers and their investors. The former may maintain business relationships with portfolio companies, and this could affect asset managers’ exercise of corporate governance rights. Hence, the previous Code and the 2020 Code require the effective management of conflicts of interest. This remains a weak area of explanation for institutions as noted in the FRC’s survey. Agency problems in investment management conduct can be seen as market failures, and the FCA has intervened into market failures in order to mitigate these problems. For example, the FCA’s Asset Management Market Study found that asset owners were not sufficiently critical of the performance delivered by asset managers and their fees and charges. This has now resulted in the imposition of a regulatory duty for asset owners to assess whether their delegation produces ‘value for money’ for the ultimate beneficiaries, therefore addressing the agency problem between asset owners and managers.

The introduction of precise regulatory duties to correct market failures and agency problems is the backdrop to the soft law in the Code. Provisions in the Stewardship Code 2020 now address more generally the monitoring of service providers (Principle 8) and how service providers should ensure that they effectively support their clients’ stewardship (Principles 1, 2, 5 and 6 for service providers). Disclosure can be treated as part of knowledge-building as to the extent of agency problems that may exist in the investment chain. Asset owners and managers should also scrutinize how service providers manage conflicts of interest (Principle 3) in order not to compromise their support of effective stewardship by institutions.

It is noted that although a key service provider, the proxy adviser industry, came under the spotlight for regulatory consideration in light of the potential power they wield in influencing institutions in their corporate governance roles, it was ultimately agreed in the European Union/United Kingdom that they should be subject to self-regulation. The Shareholders’ Rights Directive 2017 introduced mandatory disclosure obligations for proxy advisers in order to secure market and public scrutiny of their roles and influence, but arguably the standards of conduct remain self-regulatory.

The FRC’s survey surprisingly did not include service providers, which seems to indicate that focus is placed much more on asset owners and managers. Further, it may be perceived that the Asset Management Market Study has yielded comprehensive findings, so regulatory responses are targeted at precise agency problems and market failures.

It is arguable that the U.K. Stewardship Code 2020, despite being soft law, has made significant strides in articulating purpose for stewardship and clarifying a broader range of investment management strategies and activities that can be scrutinized for stewardship purposes. Being a measure in soft law and relying on a meta-governance framework, the Code guides investment firms towards internalization of its purpose-based articulations, but implementation is a private matter for contractual mandates. This remains necessary as investment allocation is a market-based matter and not under the command of regulatory fiat. Bilateral monitoring by contracting parties would be the ‘supervisory’ framework and it remains uncertain if the performance of signatories would be carefully scrutinized by regulators. The FRC relies on unassured reporting by signatories and it is uncertain to what extent the FRC would be able to tell if signatories ‘walk the talk’. The FRC’s surveys, if regularly carried out, may send signals of moral suasion for best practice, but the channels for change in practice or behavior remain private and their effectiveness undetermined.

But soft law may also be experimental and transitory, providing further information and empirical bases for governance and regulatory development. A new regulator, the Audit, Reporting, and Governance Authority, is to replace the FRC and poised to be a fully-fledged regulatory body with significant enforcement powers. Hence, a new ‘supervisory’ approach may come about for monitoring Code signatories. Further, the FRC has been coordinating with the investment firm regulator in the United Kingdom, the FCA, and it cannot be ruled out that regulatory governance may be introduced to address issues of public interest if market discipline continues to leave gaps. The coordination between the FRC and FCA in relation to investment management regulation and the implementation of the Stewardship Code 2020 may signal trends towards regulatory governance of investment management conduct where it matters)—not only to resolve agency problems, but also to serve public interest goals. The next Section turns to examine if firmer legalization has been achieved by the European Union sustainable finance regulations and their purpose-based articulation for investment management entities to heed sustainability.

C. The Implications of the Sustainable Finance Reforms in the European Union and United Kingdom

The push for sustainable finance regulatory reforms in the European Union and United Kingdom has been pronounced in recent years. Former Bank of England Governor Mark Carney played a significant role as chair of the Financial Stability Board during his term to highlight the importance of counting climate risk in financial institutions’ assets. There has hitherto been a neglected practice of counting risks such as the obsolescence of physical assets affected by net zero carbon policies, transition risks and costs, as well as stranded assets. With the launch of the Financial Stability Board’s Taskforce for Climate-related Financial Disclosures in 2017 and the adoption of the U.N. Sustainable Development Goals in 2015, policymakers in the European Union and United Kingdom have begun to address regulatory risk management by financial institutions of climate and sustainability risks, as well as the role of private finance in addressing sustainability goals and objectives. The European Union has commissioned a sustainable finance strategy since 2018 to inquire into the mobilization of private sector finance for sustainable goals and purposes, as the investment sector wields significant influence, with global assets under management estimated to be at USD$145 trillion by 2025. Besides policymakers’ initiatives, market appetite, and industry initiatives have also blossomed. The U.N. Environment Programme Finance Institute has for example led the way in facilitating legal clarity and discourse in order to encourage the private sector to engage in sustainable investments.

In relation to investment managers, it is arguable that the EU’s reform strategy is ambitious and has the potential to re-orient practices in investment management. The EU’s sustainable finance strategy has brought about reforms in capital markets regulation, particularly in mainstream investment management. These provide an early indication of regulatory ‘normification’ for the conduct of investment management, arguably aligned with public interest concerns in sustainability. Such regulatory ‘normification’ takes a step further than merely clarifying in general law the freedoms for the investment management industry to engage in sustainable objectives and investments. But such regulatory ‘normification’ cannot go too far in micro-managing how investment management is conducted, and the accountability of investment managers continues to be framed within a private framework of legal duties and obligations. Regulatory ‘normification’ in the European Union for investment management and its relationship with sustainable goals is therefore framed in a complex matrix of mandatory and market-based governance.

1. EU Sustainable Finance Reforms

The EU Sustainable Disclosure Regulation 2019 now compels all financial markets participants who engage in portfolio or fund management (whether as mainstream pension or collective investment schemes, or alternative investments funds) to integrate sustainability risks in their investment decision-making. This also includes financial services providers who provide investment-based products as part of an insurance product. Such integration relates to both conventional and sustainable portfolios or funds.

Further, if funds wish to market sustainably labelled financial products, they have to ascertain and report on sustainable achievements as meeting doubly material criteria. This means that sustainably labelled funds should achieve sustainable performance as such, apart from financial performance. The European Union has begun to provide outcome standards for environmentally sustainable financial products, which will soon extend to socially sustainable products. The sustainable label for investment products is an attempt to mobilize a market for investments that exceed conventional “socially responsible investing” or ESG-based investing, which primarily relate non-financial criteria to their materiality to financial performance. The latter market has grown due to investors’ preferences for pro-social institutions and individuals but is often criticized for opaque and uncertain quality regarding sustainable achievement.

The Sustainability Disclosure Regulation 2019 placed investment fund intermediaries under a universal obligation to disclose how they “integrate sustainability risks.” “Sustainability risk” is defined as “environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment.” Such a definition adopts a “single materiality” approach of treating a sustainability risk as salient only if it materially affects investment performance. At a baseline, the definition is not novel but is consistent with the interpretation of fiduciary duty in private investment management. It may be argued that the baseline duty pertains only to disclosure and does not change the nature of the financially focused duty of fiduciary investment management. Policymakers in the European Union have responded by clarifying that the baseline duty is not merely a duty of disclosure but also a duty to integrate sustainability risks in the governance and management of investment intermediary risk. That way, the legalization achieves the following: all mainstream investment intermediaries are at least bound by an obligation to consider material sustainability issues in their investment management, not just funds opted to be labelled as SRI or ESG. That regulatory direction is arguably novel because public policy objectives for sustainability are enmeshed with investment management conduct via regulatory fiat. Alternatively, one may argue that the baseline duty is not terribly potent because enforcement is likely to rely on market discipline and on mandatory disclosures by investment intermediaries. It also challenging for regulators to undertake clear enforcement actions regarding how firms integrate sustainability risks into their governance and risk management processes. Those aspects of enforcement are meta-regulatory in nature and allow firms some open-ended implementation within their systems, processes, and culture.

Next, an investment intermediary having 500 employees or above, or being a parent company of such undertaking, must account for principal adverse sustainability impacts (applying from June 30, 2021). That rule applies whether such intermediary engages with sustainably labelled products. Such intermediaries must account for any adverse impact of their investment decision-making processes on sustainability objectives, including how adverse impacts are discovered and what due diligence policies are deployed. Smaller entities may declare that they do not consider adverse sustainability impacts in their investment decision-making process but must clearly explain why and whether the practice cuts across all their products. That requirement means smaller entities are subject to the broad duty to integrate sustainability risks but are not subject to the specific duty to measure adverse sustainability impact. Accordingly, larger investment intermediaries are imposed with an obligation that is more socially facing in nature, i.e., to account for sustainability cost as such. The type and nature of principal adverse impact disclosed are based on double materiality—measured not only by their impact upon investment performance but also upon sustainability performance. Further, by December 30, 2022, financial services providers are mandated to integrate and disclose sustainability risks regarding adverse impacts, with transparency at the level of each financial product. Those disclosures are regarded as pre-contractual in nature and therefore encourage market discipline and legal discipline from investors.

The need to integrate and account for adverse sustainability impact compels large investment fund intermediaries to internalize impact as part of their investment management purpose. The compulsion means that, for all investment intermediaries, counting sustainability cost in the investment footprint is no longer an option—though such accounting would have mostly incorporated “socially responsible” funds. But counting sustainability costs could only change behavior if asset owners and beneficiaries cared about adverse sustainability impact, which would produce a market response to discourage such harms and thereby influence allocational steer. There is increasing evidence that owners of assets, such as pension funds, and pro-social individuals value the avoidance of adverse sustainable impact in their investment allocations. But that principle is not necessarily true for many conventional institutions and investment beneficiaries with highly heterogenous preferences.

Many large investment firms and funds targeted under the Regulation are likely to be among the largest global asset managers, a number of whom are passive managers, such as Vanguard and the world’s largest exchange-traded fund provider, Blackrock. Those firms have been observed to be engaged with corporate issuers on common issues across portfolios, such as sustainability or ESG issues. Hence, EU reforms may be regarded as facilitating the process, which is already underway. Nevertheless, those reforms may compel large fund intermediaries to assume a representative capacity in exposing and challenging their investee companies’ sustainability costs.

While large investment intermediaries are perceived to experience more radical obligations that may shape market perceptions about and preferences for double materiality, many smaller investment intermediaries can elect, subject to explanation, to be principally private-facing and potentially exempt from the scope of public-facing accountability imposed on larger firms. A large sector of investment firms are medium-sized and employ under 500 employees. Thus, there may be a sizeable market focusing only on single materiality such that whether the market would dramatically pivot towards double materiality is questionable. Nevertheless, one may argue that the reforms recognize the potential systemic impact of large investment firms’ stewardship actions and that it is not disproportionate to require greater demonstration of social accountability from larger firms in investment management.

Next, the Sustainable Disclosure Regulation clarifies that sustainably labelled finance goes beyond harm-based analyses. Harm-based analysis, part of the universal obligation to integrate sustainability risks in investment management, provides grounds for sustainably labelled financial products to be based on a higher departure point, i.e., the achievement of positive sustainability outcomes, not merely the avoidance of negative ones. “Sustainable investment” is defined as “investment products [that] should positively achieve specified sustainable outcomes and at least do ‘no significant harm’ to environmental and social objectives as a whole.” The definition of “sustainably labelled” refers to:

[A]n economic activity that contributes to an environmental objective [. . .] key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective [. . . such as] tackling inequality or [] foster[ing] social cohesion, social integration and labour relations, or [] investment[ing] in human capital or [in] economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.

Investment intermediaries that explicitly sustainably labelled products must explain how the environmental or social characteristics promoted by each product meets such product characterization—whether in active or passive management. Actively managed product requires disclosure of the strategies designed to meet the relevant characteristics, including how the intermediary defines the sustainability objective and how it measures attainment or lack thereof. The European Securities and Markets Authority (ESMA) prescribes a template for such disclosure with certain standards for comparability.

Passively managed products necessitate investment intermediaries’ disclosure if the environmental or social characterization is derived by benchmarking against indices for sustainable finance. If the “product has sustainable investment as its objective and an index has been designated as a reference benchmark,” referring only to the designated index is insufficient. Investment intermediaries must disclose how the index is aligned with those characteristics and how the aligned index differs from a broad market index. Although investment intermediaries are substantively relying on an index provider’s diligence and evaluation, some level of intelligent engagement with indexers’ methodologies is required to demonstrate why the index has been selected and how sustainable performance differs.

The Regulation provides new standards for the design and offering of sustainable financial products. Although the Taxonomy Regulation does not outlaw lower labels, such as ESG or socially responsible products, the regulatory governance of the sustainable label is intended to set standards and galvanize market choice. Those standards are regulatory steers for building investment products in the market that meet the purposes of double materiality. But the effectiveness of such regulatory policy again depends on the alignment between market choice and regulatory steering. If sustainably labelled products are more costly due to more demanding compliance obligations, then market choice and demand may be incentivized to settle for lower labels.

In sum, can it be argued that sustainability has been legalized as a new purpose-based norm for investment management conduct in the European Union? The EU regulation’s framing seems non-optional and seems to have introduced a modification to the understanding of fiduciary investment management in private law. But the regulatory provisions work with meta-regulatory firm implementation (where integrating sustainability risks are concerned), with market-based discipline for the disclosure dimensions, and with uncertainty regarding market appetite for the orientation of investment products. Arguably, despite mandatory, new obligations for investment intermediaries to integrate sustainability risks and for larger fund intermediaries to report on specific matters of adverse sustainability impact, the substantive nature of the obligations is a nudge; the purpose is ultimately to provide information and a framework to guide asset owners’ and beneficiaries’ choices. Whether such market-based regulation ultimately changes allocative steer and influences behavior of the corporate economy can only be observed in time.

But one can argue that with prescriptive templates for disclosure of adverse sustainability risks imposed on larger intermediaries, sustainability risks are evaluated as a matter of double materiality, not merely single materiality. Then to meet mandatory disclosure, some of the largest and most well-known investment intermediaries would be compelled to engage with granular items of sustainability cost to appeal to the public interest. In turn, those investment intermediaries might weigh-in more pronouncedly against their portfolio companies, or in an issue-specific manner across the board to demand information of a nature that meets double materiality needs. The Taxonomy Regulation contains amendments to the EU Non-Financial Disclosure Directive 2013 to further support the mandatory disclosure of environmental, social, human rights, and anti-corruption matters by listed corporations. Reforms are also afoot to revamp the EU Non-Financial Disclosure provisions into comprehensive disclosure obligations for corporations so that they can provide standardized and comprehensive disclosures on sustainability matters. The ESMA welcomes and is collaborating with bodies, such as the International Financial Reporting Standards body, to develop meaningful metrics of sustainability performance. The legalization carried out in the European Union reforms is poised to bring about a new landscape of transparency that galvanizes the public alongside market pressure. Dismissing the reforms as merely market-based regulation subservient to market behavior may be premature.

2. U.K.’s Sustainable Finance Reforms

In June 2021, the U.K. FCA unveiled its consultation for sustainable finance reforms for the investment management sector. Those reforms focus only on climate risks since the FCA proposed to introduce a baseline duty for all investment asset management entities, including life insurers, to make mandatory reporting based on the Taskforce on Climate-related Financial Disclosures (TCFD). One may see the proposal as a reasonable introduction of a mandatory duty because TCFD is already imposed on all premium-listed entities on the London Stock Exchange. Mandatory TCFD reporting by investment managers is required at entity level and at product or portfolio level. Regarding entity-level reporting, investment managers subject must disclose how they together manage climate risks according to the four components of TCFD reporting: (1) how their business strategy and governance take climate risk into account; (2) how their risk management policies and framework take climate risk into account; (3) how firms employ scenario analysis to map and evaluate climate risk; and (4) what metrics and targets are used for measuring the financial risks and opportunities from climate risk (guided by examples provided in the TCFD framework).

On product- or portfolio-level disclosure, investment management entities should include for each product or portfolio managed a list of standardized metrics on the product or portfolio’s climate footprint. That information should be provided to investment managers’ clients via continuing disclosures in annual and periodic reports or on demand. Reforms in pre-sale communications are a work-in-progress. The climate metrics to be disclosed include the greenhouse gas, GHG, carbon emission levels implicated by the product or portfolio, the carbon footprint measurement, and the Weighted Average Carbon Intensity (WACI) developed by the Partnership for Carbon Accounting Financials. Other metrics can also be included. Product- and portfolio-level disclosure also include disclosures regarding the investment manager’s business strategy, governance, risk management and policies, and approaches to scenario analyses relevant to the product or portfolio.

The United Kingdom’s regulatory approach is currently more limited than the European Union’s approach. TCFD focuses on the financial risks from climate-related risks and opportunities and is therefore complimentary to mainstream financial institutions’ focus on financial performance. That focus is currently narrower than the European Union’s embrace of double materiality for large investment firms’ mandatory reporting of adverse sustainability impact, which is evaluated in financial and non-financial terms. Further, the European Union’s range of sustainability goals and metrics for double materiality is broader than the United Kingdom’s focus only on climate risks. It may however be argued that the United Kingdom has first focused on climate risks in sustainable finance regulation, as carbon footprint and greenhouse gas emission measurements are established metrics and lend themselves to be perceived with greater scientific accuracy than social development measurements. Nevertheless, metrics are developing for various areas of sustainability, such as SDG compliance.

The European Union’s approach of adopting a mixed public-and-private approach to developing and governing metrics for sustainability indicators facilitates the infusion of public interest into metrics development, hitherto dominated by the private sector to further a broader agenda of steering sustainable finance reforms according to public interest and of preventing disengagement of the sustainable finance market from public interest goals. The U.K. is likely to support private sector metrics development, by the TCFD and the International Financial Reporting Standards Foundation, reflecting its preference to allow market actors to steer sustainable finance allocations and priorities. U.K. policymakers should ask whether incentive-based calculations and internalization of climate risk is always aligned with public interest goals and ascertain the extent those goals are really served. However it may be argued that the UK’s approach is sounder as regulators may not be able to decide which sustainable objective has priority if a number of different sustainable objectives come into conflict as a result of market choice. For example, investment institutions may favour solar energy investments, but solar energy projects entail controversy with community rights, such as the rights in farming and food security. On the one hand, would investors price accurately holistic, social risks in investment allocations and valuations? But on the other hand, regulators are not necessarily better-placed to intervene in market choices. Regulators could overstretch mandates by extending public interest goals not primarily related to financial regulatory goals, such as investor protection.

Nevertheless, one may argue that the European Union’s reforms do not achieve markedly different effects from the United Kingdom’s reforms; the European Union’s introduction of a mandatory duty to integrate sustainability risks for all investment management entities is also based on single materiality. The connection between public interest goals and double materiality is only imposed on a small set of large investment management entities. Further, the United Kingdom’s narrower approach, which currently focuses on climate risks, also facilitates firm compliance through the relative clarity of TCFD’s template. As discussed above, the meta-level governance articulated in the expectations to integrate sustainability risks can be vague in terms of the processes and frameworks required of investment firms.

On the marketing of sustainable investment products, both the UK’s and EU’s approaches are market-based, but the European Union relies more on legalizing new mandatory transparency to inform market choice. The U.K. FCA has issued guidance to investment firms warning that ESG or sustainably labelled products should show substantive connections to investment objectives and strategies and should not be meaningless in case of mis-selling. Existing periodic disclosure obligations for investment funds should also include ESG or sustainability specific performance information for such labelled products. The European Union’s definition of sustainably labelled products and its Taxonomy of environmentally sustainable products provide standards for investment objectives and performance that can enhance investor confidence and double materiality baselines for the public interest goals sought to be achieved concurrently. This approach more robustly appeals to pro-social investors looking to verify double materiality outcomes. The United Kingdom is also mindful of greenwashing and is in the process of introducing its own Taxonomy. This work-in-progress also serves the public policy of meeting the U.K.’s commitment to achieve net zero greenhouse gas emissions by 2050.

The pronounced coupling of public interest goals with sustainable finance regulation in the European Union provides an interesting hybrid approach to nudging financial allocation as well as governing investment management conduct. The U.K. is warming up to this approach and in sum, sustainable finance reforms reflect an unprecedented ‘purpose-based’ regulation of investment management conduct. In consolidating with the purpose-based steers in the U.K. Stewardship Code 2020, code signatories need to be keenly aware of the wider context for investment fund allocation and management and increasing regulatory scrutiny. The framework for governing the purpose of investment management comprises of soft law, meta-level governance, market-based discipline and regulatory steer, overall providing a balance between leaving to contractual implementation and painting the boundaries of public interest. Such designs of modern governance are not in the vein of central planning or allocation, yet do not subscribe to laissez-faire principles. The United Nations Environment Programme Finance Initiative (UNEP FI) reports of 2019 and 2021 have also paved the way for integration of a traditionally private law-based paradigm with modern concerns of a broader nature.

Modern investment management contributes to and is part and parcel of global capital allocation. Policymakers are increasingly scrutinizing the purposes to which such capital is put. It may be argued that as many countries struggle with economic recovery in the wake of the Covid-19 pandemic, the needs for financial allocation at a macro level would more than ever become questions of public interest, in addition to the long-running issues of climate change, environmental sustainability, and social development that have been on policymakers’ agendas for a long time. The governance of investment fund management is transcending the paradigm revolving around the micro needs of private entrustment and allocation and moving towards the macro needs of global capital allocation.

D. Conclusion

From the introduction of shareholder engagement as a norm for stewardship, the regulatory governance of investment management conduct has been ramping up, not to mention areas not covered in this paper such as policymakers’ scrutiny for systemic risks. As investment funds and asset managers assume control of increasing global assets under management and enjoy significant allocative power, public interest in the exercise of such power increases correspondingly. It is inevitable that societal and public expectations would be augmented, and the governance needs for the industry would rise. This article argues that the UK Stewardship Code 2020 is a graduation from an earlier experimental period which focused on the narrower and process-based norm of shareholder engagement. The Code has broken new ground by articulating purpose-based steers for investment management, providing the starting point for a type of governance that may come to define the regulation of investment management in the future. Indeed, sustainable finance reforms such as in the European Union and United Kingdom may provide the crucial kickstart to introducing non-optional integration of sustainability risks and goals into mainstream investment management in due course. Purpose-based governance, albeit in its soft law beginnings, is arguably a new trajectory for calibrating the relationship between private investment management and regulation, reflecting the public interest and expectations for the future of the industry.