“Active Investor Stewardship”: Can stewardship be overlabelled?

Earlier this year the Financial Conduct Authority (FCA) in the UK closed its three-month consultation on its proposed Sustainability Disclosure Requirements (CP22/20). The FCA is currently reviewing the consultation responses and intends to publish its final rules and guidance by June 2023. The proposed regime (SDR), addressed to asset managers and their UK-based fund products and portfolio management services, is part of the FCA’s ESG strategy which aims to advance the UK market for sustainable investment products and achieve the UK economy’s transition to net zero in implementation of the UK Government’s Greening Finance Roadmap. The FCA’s key goals are to build trust among consumers in sustainable products, address concerns over greenwashing and improve the transparency of the broader sustainability ecosystem.

The SDR introduces sustainable investment product labels and proposes product- and entity-level disclosures (both consumer-facing and at a more granular lever for institutional investors and other stakeholders). The proposed rules raise a wide range of issues but one stands out, namely, the inclusion of investor stewardship, “active investor stewardship” in the FCA’s words, as one of the key criteria to distinguish between the three categories of investment labels to be used for sustainable investment products: “sustainable focus”, “sustainable improvers” and “sustainable impact”. Among others, the FCA proposes “active investor stewardship” aimed at “improving the environmental or social sustainability profile of assets” as the primary channel of the “sustainable improvers” label. While the introduction of both the proposed three sustainable labels and the recognition of investor stewardship as a key sustainable investment strategy (Principle 5 of the SRD) are welcome, I’d like to draw attention to a terminological confusion created by the FCA’s addition of the adjective “active” to the already obscure term investor stewardship. In my response to the consultation, I argue against the adoption of the term “active investor stewardship” by the FCA Handbook for at least four reasons.

Using the adjective “active” does not add any meaningful value to the already overloaded term investor stewardship

First, “active” commonly refers to portfolio management when it means deliberately selecting the investments that make up the portfolio as opposed to passive portfolio management which mimics a market index. Originally, investor stewardship was advanced by policymakers as a means to elevate institutional investors as shareholders of public companies to an active monitoring status at the firm-specific level. I have used the term micro-level shareholder stewardship to refer to this original conception of stewardship, which was introduced by the UK Stewardship Code 2010 (revised in 2012) and diffused around the world. When it comes to asset managers, the policy-aspired micro-level shareholder stewardship is compatible (at best) with active and activist investment strategies. Passive investment strategies, by contrast, are not easily compatible with micro-level shareholder stewardship except in cases where the fund selects a few key companies to engage with the aim that there would be a spill-over effect to non-targeted, portfolio companies. However, the UK Stewardship Code 2020 introduced a significant overhaul of how investor stewardship is understood. Among others, it expanded investor stewardship beyond micro-level shareholder engagement to include portfolio- and macro-level engagement with all assets in recognition that asset owners and asset managers can act as “guardians of market integrity” and work with other stakeholders, including regulators, associations and not-for-profits, in identifying and monitoring market-wide and systemic risks. This has important implications for fund governance itself. Whereas micro-level shareholder stewardship requires an integrated, active approach to monitoring individual investee companies and a preference to use voting rights as a stick instead of the market carrot, portfolio- and macro-level stewardship – aiming at minimising market risks – is more easily compatible with highly diversified, often referred to as passive, investment strategies. What is more, for the purposes of the FCA’s sustainable finance labels, targeting systematic risk across the market, such as climate change or Diversity, Equity and Inclusion (DEI), rather than idiosyncratic risk, is likely to be the investor’s key contribution channel towards achieving sustainability objectives. Therefore, using the adjective “active” does not add any meaningful value to the already overloaded term investor stewardship and may shield away passive managers who undertake stewardship activities.

Adopting the term “active investor stewardship” may, therefore, cause unnecessary confusion to fund managers without clarifying how carrying out investor stewardship at the fund level can qualify for the “sustainable improvers” product category.

A second – but related – reason why qualifying investor stewardship as “active” may be of little value is the need to differentiate between investor stewardship at the firm/entity level, on the one hand, and investor stewardship at the fund/product level, one the other. The current stewardship regime, as this is promoted and supported by the UK Stewardship Code 2020, is about the firm/entity level. The FCA’s proposed labelling and disclosure regime, on the other hand, relates to investor stewardship at the fund/product level. An (asset manager) firm/entity may have a stewardship policy and produce annual reports to comply with the UK Stewardship Code 2020, but it may offer a variety of sustainable funds/products (those with an explicit and/or environmental objective) that adopt active or passive investment management strategies. The firm’s investor stewardship policy is not automatically relevant to all the firm’s funds/products. An actively managed fund may not engage in any investor stewardship activities, whereas a passively managed fund may pursue micro-level investor stewardship with a few selected companies and/or engage with micro-level stewardship, or vice-versa. Adopting the term “active investor stewardship” may, therefore, cause unnecessary confusion to fund managers without clarifying how carrying out investor stewardship at the fund level can qualify for the “sustainable improvers” product category.

A third reason why the term “active” should be avoided by the FCA’s Handbook is because in both academic literature and business circles the adjective “active” is often used to differentiate between different types of “ownership” and “engagement”. For instance, the terms “active ownership” and “active owners” are used to oppose to “passive owners” and rational passivity or “reticence” on the part of institutional investors. Active ownership refers to the vigilance of institutional investors as shareholders/shareowners and their propensity to engage. It includes both formal exercise of shareholder rights and informal forms of engagement (such as dialogue and meetings). It includes reactive or strategic forms of shareholder activism but also less systematic forms of engagement. Active ownership is clearly a narrower construct than investor stewardship, as it only refers to “shareholder stewardship”, that is how institutional investors monitor and engage with portfolio companies. The adjective “active” also often cooccurs with engagement, but investor stewardship as reconceptualised by the UK Stewardship Code 2020 goes beyond active ownership, active engagement and even beyond listed equities. It is about “responsible allocation, management and oversight of capital” and has both corporate governance and investment management limbs.

Finally, even though international alignment of sustainability disclosures is important (particularly with the EU SFDR and the proposed SEC provisions), it needs to be clear to both investors and consumers that the FCA’s Principle 5, building on the FRC’s UK Stewardship Code, understands investor stewardship in a much broader context, not limited to shareholder engagement and voting. In other words, the disclosures required under Principle 5 of the SDR proposals relate to all aspects of entity- and/or product-level investor stewardship that contribute to the sustainability’s products sustainability objective, and not only to engagement and voting as the SFDR and SEC do.

Just as the FRC’s Code has moved away from an exclusive focus on “active” shareholder engagement as the recommended means of exercising investor stewardship, so should the FCA drop the use of the term “active investor stewardship” in favour of “investor stewardship” for its labelling and disclosure regime.

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By Dr. Dionysia Katelouzou, Reader in Corporate Law at The Dickson Poon School of Law, King’s College London and Associate Editor of the ECGI Blog.

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Dionysia Katelouzou,