05 April 2019

Presentation by Rob Everett at the NZ Capital Markets Forum

Thinking beyond shareholders - 21 March 2019

The FMA is a conduct regulator.

The Financial Markets Conduct Act, the Capital Markets Development Taskforce, the intent of the changes to Securities Commission’s mandate and powers all point us there.

Our legislative mandate is about markets and investments, financial reporting, auditors, continuous disclosure, oversight of regulated markets like NZX.

Our mandate is also about licensing and monitoring “certain sectors of retail financial services – focused on investment products and services - managed funds, derivatives issuers, advice.”

We inject “conduct” and the controls, processes and governance in firms that drive conduct, through the licensing framework in the FMC Act.

We know, of course, that behaviour is “learned” and culture is created by those that lead. And for those reasons, we focus on what financial services boards and managements are doing.

The government is considering whether to ask us to do the same, with or without licensing, for retail banking and insurance. It’s a big ask frankly, especially alongside major expansion of our regulatory responsibilities around financial advice.

The thread bringing it all together is how those who buy financial products or financial services are treated - whether it’s by issuers, sellers, advisers or managers of those products. It’s about how the sell-side behaves and who it is serving.

We expect the sorts of people who have been speaking here today to be relentlessly focused on treating investors and customers right. I don’t have to point very far, to show you why I might be sceptical as to whether the current DNA of financial services would allow the FMA to give the industry the benefit of the doubt.

So we intend to be active & assertive in pushing the pace of change.

Today though I want to make a broader point.

Much of what I have just said is clearly applicable to financial services but it is also much more broadly relevant.

And the point is this - the Milton Friedman model, where the responsibilities of a listed company board are primarily aimed at returns for shareholders, and the competitive dynamics of the “market” itself being able to weed out those who do harm, is broken. Actually, it’s not broken, because it was never a valid or sustainable model in the first place.

Now I haven’t gone communist on you. 20 years at Merrill Lynch did all sorts of things to me but it didn’t quite achieve that.

What it did show me was that when a firm like that shifts from a client-focused model to a shareholder and employee-focused model, bad stuff happens.

Across the globe, people are asking themselves – what purposes do companies serve, what are the duties of their Boards, and who are those owed to......

Well, there’s a lot in there but I am going to focus first on the question of the duties of Boards and then on whom Board directors are there to serve.

What is fair to expect of Boards?

I can reel off a bunch of major corporate names that have been associated with misdeeds that can fairly be pointed at their Boards - BP, Volkswagen, Siemens, Rolls Royce, BhS, Enron, WorldCom, Parmalat, FIFA.

All contained significant elements of failure and misconduct that was engaged in by management and either encouraged, tolerated or ignored by boards.

For that reason, within current regime operated by FMA - focus on conduct and on boards/senior management’s responsibility for that.

So in financial services, but also more broadly, regulators and policymaker have focused on how boards exercise their oversight - what do they discuss, what data and information do they ask for, how do they know what is really going on? Given the outsize rewards for management, we ask Boards how they incentivise, reward and direct their executives and we ask about how the executives organise and direct their firms.

So this focus on what is expected from Boards opens up the broader question of who they serve.

This is particularly challenging in somewhere like NZ where the financial services firm boards are often “subsidiary boards” - ie they have to balance serving and directing the NZ entity, while under the direction and resource constraints of a parent company in another country. A country and parent’s entities which, despite the similarities, quite naturally put their own agenda first.

This is quite stark when you look at the tolerance for lying to and misleading customers and regulators in the Australian financial services industry. (Ignoring for a moment the fact that NZers run large swathes of Australian financial services), how can the public or regulators be confident in the good intentions of the NZ arms of Australian financial services firms when we look at what has happened at HQ?

As more of NZ’s corporate sector and the biggest players in its financial services sector are owned overseas, identifying the cultural make-up and direction of the relevant sectors gets tricky.

I’ll stay well clear of the political and social elements of that question, and merely remark that it puts the focus of the regulators very much on local boards and local management.

Turning the gaze inwards to regulators for a moment - it also indicates that a far greater degree of co-operation and collaboration with overseas regulators is necessary.

Here in NZ, as a new era of collaboration and shared supervision is emerging with the Reserve Bank of NZ, as the prudential half of Twin Peaks regulation, so it is with ASIC as the Trans-Tasman half of conduct regulation over Australian and Australian-owned firms. I know and rate James Shipton well, and of course, our own Sean Hughes is busy drawing his pistols in his new role back at ASIC. We are engaging more with ASIC in a genuinely collaborative supervisory way and across a broader range of topics that we have ever done.

I also salute the openness and transparency and the vision that Adrian has already brought to the RBNZ and to the NZ Council of Financial Regulators.

When the IMF reviewed NZ’s financial services architecture in 2016 they were pointed about the need for the RB and APRA to work more closely together. I am going to stay well clear of the RB’s proposals for stronger capital bases for NZ banks, but the need for the prudential supervisors on either side of the Tasman to work closely together seems apparent.

Questioning the primacy of shareholders and shareholder returns

Back to what we expect of Boards.

As the title of this speech makes clear, I’m looking to provoke the discussion about boards serving a much broader set of stakeholders than just shareholders.

Yes, Directors owe their duties to those who entrust their hard-earned capital to the company. Of course.

But it is employees too. Many jurisdictions broaden those duties to their local community, the environment and of course in many cases to their regulators (assuming they operate in a regulated space of course).
Last and not least to customers. Those who pay for products or services. They have a right to be treated with respect, not to be lied to, misled or avoided when they aren’t happy with how they have been treated.

John Duncan mentioned Milton Friedman earlier - as I commented, the accepted model of capitalism post-Friedman, and encouraged by Greenspan, has been an unfettered pursuit of corporate profits with the assumption that rational and judgemental markets will weed out the crooks and the incompetents, and the “best” will rise to the top. All of us in financial markets know that markets are often not rational and nor, it seems, are parliaments or electorates.

In 1970, Friedman said that those who claim “that business is not concerned ‘merely’ with profit but also with promoting desirable ‘social’ ends . . . They are — or would be, if they, or anyone else took them seriously — preaching pure and unadulterated socialism.”

Unfortunately, we have plenty of reason to challenge Friedman’s model.

One flaw in the principle of shareholder primacy is that the shareholder is often no longer the person or entity at the biggest risk from the conduct of the company. Reductions in profit or even bankruptcy at any particular company are not existential threats to global fund managers or other institutional investors running huge, diversified portfolios. Employees have much more at risk.

As we have seen here with a situation like Mainzeal, suppliers likewise often have more at risk than shareholders especially when they become, whether they like it or not, creditors of the company. BP risked death and injury to its employees, irreversible damage to the environment and risk to the livelihoods of the local fishing fleet, in cutting corners and shaving off costs on its Deepwater Horizon rig.

Social licence is a phrase that is becoming over-used but I believe that most market participants now accept that all corporate structures have responsibilities to a broader set of stakeholders than their shareholders.

Larry Fink of Blackrock said in his letter to CEOs last year that the time had come for a new model of shareholder engagement. He said:

To prosper over time, every company must not only deliver financial performance but also show how it makes a positive contribution to society. Companies must benefit all their stakeholders, including shareholders, employees, customers and the communities in which they operate

The Europeans (especially the Germans) have been down this road for a good while - building broader notions of stakeholders into their companies law. The Brits have gone this way too. Unfortunately, I’m not convinced it has been especially effective in either place.

But nonetheless, whether it is customers or employees, the environment or the communities in which they operate, I believe companies need to ask themselves what their purpose is and what their values are. And if it is purely to make money at the expense of everyone else they should not be allowed to operate.

In his CEOs letter this year, Fink focused on the need for companies to create and articulate a purpose for existing. This was also discussed at the panel earlier. Fink said:

Profits are essential if a company is to effectively serve all of its stakeholders over time – not only shareholders, but also employees, customers, and communities.

Similarly, when a company truly understands and expresses its purpose, it functions with the focus and strategic discipline that drive long-term profitability.

Purpose unifies management, employees, and communities. It drives ethical behaviour and creates an essential check on actions that go against the best interests of stakeholders.

Purpose guides culture, provides a framework for consistent decision-making, and, ultimately, helps sustain long-term financial returns for the shareholders of your company.”

All of those points are equally valid when you substitute “purpose” for “values”.

To make the point that having a clear purpose, and according to ethical values, should be completely aligned with shareholder profits, he went on to say:

Companies that fulfil their purpose and responsibilities to stakeholders reap rewards over the long-term. Companies that ignore them stumble and fail. This dynamic is becoming increasingly apparent as the public holds companies to more exacting standards. And it will continue to accelerate as millennials – who today represent 35 percent of the workforce – express new expectations of the companies they work for, buy from, and invest in.”

That’s probably enough of Mr Fink for now.

The panel made the point that values need to be organically created and developed – it is very hard to impose a value-set on a bright, driven workforce if they do not feel authentic and right.

Public trust

In terms of public trust in business and in our capital markets, economic well-being is driven by a strong, productive and growing economy. But for that to be sustainable, it has to have the support and confidence of the wider public and right now, across the world, neither the corporate nor the fin services sector are trusted or liked.

Here it is better. Surprisingly so, to be honest. And, no doubt there’s a whole range of factors in that. But let’s not be complacent - the organisations represented in this room cannot lose the trust of the public - either for their own sake or for the sake of the wider economy. So a relentless focus on good products and useful services offered and sold to well-informed and protected customers is required.

As examples of where we have seen some common themes with other jurisdictions where conduct regulation has had longer to distil the issues, we have pointed to a range of issues in financial services here.

These include avoiding a set and forget approach to legacy and outmoded products, and a refusal to just sit by and watch when people buy, or use, products in a way or for reasons that are not suitable or appropriate.

Taking outrageous levels of fees on old investment products “because it’s in the contract” might be legal but it’s not right. Charging fees for no service “because no-one has noticed and we managed to pull the wool over the regulators’ eyes” is not right. Charging dead people........failing to fix known issues because there are technical complications......where to stop.

These behaviours apply equally across a whole range of corporate sectors. Some of the Commerce Commission action against Viagogo, Vodafone and Youi insurance reflect that.

Some might argue that competition will ultimately deal with those who treat any of those constituents with contempt and so it will - but experience tells us - not quick enough. Not before customers have been mistreated, rivers polluted or employees harmed.

This is mostly why we have conduct regulators or consumer protection agencies. Frankly, without wanting to do myself out of a job, that’s a shame but it is the reality.

Doing the right thing – pushing back on shareholders

I know from close personal experience that most people in financial services do the right thing every day. I know too that most people on company boards are determined to operate within the law and for the broader social good. The problem is, that on an institutional basis it’s easy to say - and very hard and very expensive to do. And shareholders who don’t like the return on their investments will vote with their feet and move their investment capital to the next bank or fund manager or insurer or corporate.

I’m sure some shareholders have a genuine social conscience and of course, they need to get a return on their investment and get rewarded for putting their capital to work. No-one I know of is arguing otherwise.

But if all that matters to boards and CEOs is the share price and how to keep demanding shareholders happy, the issues we’ve seen in financial services in Australia and elsewhere in the corporate world will happen here.

So boards and executives need to anchor themselves in what is good for NZ and the communities in which they operate and they need to push back on parent companies and shareholders who push them in the other direction.

Boards have to balance serving the shareholders by doing the right thing. And as Hayne pointed out in the Australian Royal Commission that is a far higher standard than complying with the law, or doing stuff that may not be in the spirit of the law, or does not “affirmatively” and provably breach it.

I think the tide has turned in terms of what the public and the community at large expects from its corporate leaders. Issues of trust and fair treatment of those that companies come in contact with show up clearly in the global research as the top indicators for employees and customers.

To some extent, the law hasn’t caught up yet although recent consultations on corporate governance standards in both Australia and the UK reflect the general direction.

My parting shot for this excellent conference and all who have spoken at it and attended it is to understand that regulators and the law should reflect the expectations and needs of society. And those goalposts are moving.

Thank you