The forthcoming European Shareholders’ Rights Directive II (SRD II) aims to strengthen transparent and active engagement by shareholders of listed European companies. What are the implications and what should in-house lawyers be doing to prepare? Lucy Trevelyan reports.
A review of the Shareholders’ Rights Directive (SRD I) was ordered after the financial crisis revealed that shareholders often supported managers’ excessive short-term risk-taking.
‘One of SRD II’s objectives is to avoid such reckless behaviour in the future and to substitute the high-risk, short-term return corporate mentality with one directed towards sustainable long-term planning and enhanced transparency and disclosure,’ says Philippe Hoss, a partner at Elvinger Hoss Prussen in Luxembourg.
The main shortcomings that SRD II aims to correct, he says, are short-termism in the investment universe, insufficient oversight on directors’ pay and of related party transactions and ineffective interaction between companies and shareholders in cross-border situations.
‘While SRD I can be seen as putting shareholder rights at its forefront, SRD II is focusing on the corporate issuer communicating in a transparent way with its shareholders. To do this there will be more regulation and more cost for financial intermediaries both inside and outside the European Union’
Tim Matthews, a partner at Barlow Robbins
‘SRD II was introduced under the assumption that the current structure in corporate governance does not allow for shareholders to have an active participation in the life and decisions of their respective corporations,’ he adds.
SRD II will create a shift towards the observance of company rights to communicate with its shareholders, says Tim Matthews, a partner in the corporate and commercial team at Barlow Robbins. ‘While SRD I can be seen as putting shareholder rights at its forefront, SRD II is focusing on the corporate issuer communicating in a transparent way with its shareholders. To do this there will be more regulation and more cost for financial intermediaries both inside and outside the European Union.’
The revised Directive – most of the provisions of which must be implemented by EU Member States by 10 June 2019 – introduces a right for shareholders to vote on the remuneration policy of their directors, with director performance being assessed using a variety of criteria and not just financial ones. The remuneration policy will also have to be publicly disclosed after the shareholders' vote at the general meeting.
The European Commission’s reasoning behind this new measure is that directors’ remuneration plays a key role in aligning the interests of directors and shareholders and ensuring that the directors act in the best interest of the company, rather than focusing on rewarding themselves personally. Shareholders also often do not have sufficient tools to express their opinion on directors’ remuneration under the current framework.
‘The new Directive provides that a remuneration policy should contribute to the company’s business strategy, long-term interests and sustainability and explain how it does so,’ says Fergus Bolster, a partner at Matheson in Dublin.
‘Where a company awards variable remuneration, the remuneration policy is required to set clear, comprehensive and varied criteria for the award of the variable remuneration,’ Bolster says. ‘Furthermore, the policy is required to indicate the financial and non-financial performance criteria, including, where appropriate, criteria relating to corporate social responsibility, and explain how they contribute to the company’s business strategy, long-term interests and sustainability.’
Guy Harles, a partner at Arendt & Medernach in Luxembourg and Senior Vice-Chair of the IBA Corporate and M&A Law Committee, says that while he believes that aggregate figures are important and are the philosophy that forms the basis of the remuneration policy, he is less convinced that disclosure of individual remunerations adds any information. ‘It also runs, in my opinion, contrary to data privacy rules. I am sceptical as to [the] effectiveness of the new measures.’
Shareholder identification and voting rights
The European Commission recognised the difficulty of identifying the voting shareholders as being one of the principal obstacles in obtaining full shareholder participation in the corporation, says Hoss. To this end, SRD II will give companies more rights to identify their shareholders and obtain information about them, although Member States may set a threshold of a minimum holding of 0.5 per cent of shares or voting rights before a company can request shareholder identification.
Intermediaries, such as banks, will meanwhile be obliged to facilitate the exercise of shareholders’ rights domestically and across borders (for example, to participate and vote in general meetings) and provide them with information required to exercise those rights.
The practical difficulties and costs involved with exercising the right to vote cross-border is a major issue in practice for some Member States, says Louise Celia Korpela, an attorney at Gorrissen Federspiel Advokatpartnerselskab in Denmark.
‘More than half of the share capital of Danish listed companies is held by non-Danish investors,’ she says. ‘In practice, however, the non-Danish shareholder base does not have the ability to exercise its relative influence at general meetings as approximately one-third of proxy votes cast by non-Danish investors on average is deemed invalid due to formality issues. This effectively precludes a large part of the Danish companies’ shareholder base from exercising its shareholder rights.’
In addition, she says, non-Danish investors who are retail investors or have smaller holdings are less likely to try to exercise their shareholder rights in Danish companies due to unfamiliarity with the process and the often disproportionately high costs involved.
‘To alleviate these practical issues, we would have preferred that the EU had included a more practical detailed regulation of how shareholder rights should in practice be facilitated cross-border, rather than leaving much of the regulation to each Member State.’
Transparency of institutional investors, asset managers and proxy advisers
SRD II requires institutional investors and asset managers to either develop – and publicly disclose – a shareholder engagement policy or explain why they have chosen not to do so.
This policy will outline how they integrate shareholder engagement in their investment strategy and the engagement activities they carry out. It will also include policies to manage actual or potential conflicts of interests, in particular where the institutional investors or asset managers or their affiliated undertakings have significant business relationships with the investee company.
Many institutional investors and asset managers use proxy advisers who provide research, advice and recommendations on how to vote in general meetings of listed companies. While proxy advisers play an important role in corporate governance by contributing to a reduction in the costs of the analysis related to company information, the European Commission says, they may also have an important influence on the voting behaviour of investors and will therefore be subject to transparency requirements and a code of conduct under SRD II.
These requirements, says Eriprando Guerritore, a partner at Paul Hastings in Milan, will be new to the systems of many Member States, including Italy. ‘Proxy advisers will have to report on their application of the code of conduct. They should also disclose certain key information relating to the preparation of their research, advice and voting recommendations. That information should remain publicly available for a period of at least three years to allow institutional investors to choose the services of proxy advisers taking into account their performance in the past.’
Hoss warns that intermediaries, institutional investors, asset managers and proxy advisers should initiate projects to become compliant by the middle of 2019, as the Directive does not provide for a grace period after its implementation.
Related party transactions
The new rules will require companies to publicly announce ‘material related party transactions’ that are most likely to create risks for minority shareholders by the time of their conclusion, with all the information needed to assess the fairness of the transaction. Companies will also have to submit these transactions for the approval of the general meeting of shareholders or of the board to provide adequate protection for the interests of the company.
Any director or shareholder involved in a related party transaction must not participate in the approval or vote, says Matthews. ‘However, Member States may allow a related party who is a shareholder to vote if national law has appropriate safeguards preventing approval, despite a majority of unrelated shareholders or independent directors opposing the transaction.’
Member States, Matthews says, are required to define what constitutes a ‘material transaction’. ‘The definition must take into account both the influence that the information about the transaction may have on shareholders’ economic decisions, and the risk that the transaction creates for the company and shareholders who are not a related party, including minority shareholders.’
‘Compliance programs should be initiated to provide the information requested by SRD II, which also triggers material data burden mainly on asset managers and institutional investors’
Eriprando Guerritore, a partner at Paul Hastings
At a minimum, the public announcement of a material transaction must contain information on the nature of the related party relationship, the name of the related party, the date and value of the transaction and other information necessary to assess whether the transaction is fair, he says.
‘Member States may require this announcement to be accompanied by a report assessing whether the transaction is fair and reasonable from the perspective of the company and unrelated shareholders, as well as explaining its assumptions and methods,’ he adds. ‘Any such report would be produced by an independent third party, the board, the audit committee or a committee, the majority of which is composed of independent directors. Related parties must not participate in the report’s preparation.’
While a higher level of transparency on costs and a broader duty to disclose and gather personal data and information is beneficial for the investors and the market, it entails certain material costs – at least initially – to be borne by the companies which need to adjust to such change, says Guerritore.
‘Compliance programmes should be initiated to provide the information requested by SRD II, which also triggers material data burden mainly on asset managers and institutional investors. The application of SRD II could entail additional compliance costs for smaller custodians, asset managers and other intermediaries, while larger players might be able to rely on their existing capabilities. In particular, the requirement that institutional investors publicly disclose the means by which they measure the performance of their fund managers will be especially burdensome for pension funds and similar institutional investors.’
It is the duty of Member States, he adds, to establish rules on the measures and penalties applicable in case of breach of the national provisions implementing the SRD II. These will only become clear once domestic implementing legislation is introduced.
Advice for in-house lawyers
In-house lawyers should use the time ahead of the implementation deadline to review their employer company’s compliance level in the light of the SRD II, especially in respect of remuneration policy, the remuneration report and disclosure obligations, and then prepare a step-plan for the preparations required to bridge the gap between the compliance level and the expected required compliance level under the SRD II, says Korpela.
‘In respect of the remuneration report, we further recommend that in-house lawyers engage external advisers to prepare a mock-up report for consideration at a remuneration committee meeting (for example, during H1 2019) and ensure that the senior management is sufficiently aware of and prepared for the new level of disclosure required,' she says, citing individual information and five-year comparison tables as examples.
‘In respect of the new requirements for transmission of information between the company and its shareholders, we recommend that in-house lawyers align any technical requirements with the registered nominees as well as any share registrar provider and establish a process for exchange of information between the issuer and each nominee.’
In general, in-house lawyers should also keep a close eye on any local draft implementing acts being sent to public consultation processes or similar as well as all EU guidance on the SRD II. ‘On 3 September 2018, the final implementing regulation EU 2018/1212 was approved and other guidelines are expected to follow on, for example, the format of the remuneration report, during the winter of 2018 and spring 2019,’ Korpela adds.
Even though many Member States have not adopted implementing measures yet, in-house lawyers should start preparing now for its introduction, says Guerritore.
‘It might be advisable to start by clearly understanding and assessing SRD II’s impact on the company’s operations and that of its clients and, if needed, actively engage and voice any concerns with the local regulatory authority prior to the date on which implementing measures are issued to ensure the impact and implications of SRD II are achievable for the industry.’
In-house lawyers should also be organising the adoption of adequate tools and safeguards to comply with the obligations deriving from the SRD II legal framework, he says. ‘Further, they should start getting familiar with the implications of this Directive for their company and after assessing the investors needs and views, review relevant company programmes and policies with respect to SRD II rules and investors’ expectations. SRD II establishes certain information requirements along the entire investment chain, therefore several actions will need to be promoted to provide such information.’
Information and any other relevant documentation should also be prepared in advance for board meetings, as well as a first draft of the remuneration report explaining the relationship between pay and performance according to the ‘say on pay’ rules, he says. ‘Companies, meanwhile, should be appointing someone responsible for the supervision and management of compliance issues or prearrange the use of suitable IT applications to carry out the necessary checks and communications.’
How effective is SRD II likely to be?
The Directive, says Harles, is in line with the goal of the EU to create more shareholder democracy in listed companies. Although he feels it is ‘a laudable exercise’, he is less convinced that the ultimate aim will be achieved.
‘The number of companies concerned is limited, as only entities which have their registered office in a Member State and the shares of which are admitted to trading on a regulated market situated or operating within a Member State, are concerned. Luxembourg, for example, has quite a large number of listed entities; however, they frequently are listed on the New York or Hong Kong stock exchanges and are thus not within the scope of the Directive. The same will soon be true for companies listed on the London stock exchange.’
Korpela, however, believes its implementation may have an indirect effect on companies outside of the EU, for example, in terms of transmission of information between the issuer and its shareholders through the chain of intermediaries – which may contain intermediaries based outside the EU – where the intermediaries may wish to align all transmission of information regardless of whether it is from an EU issuer or not.
‘Further, the increased disclosure and transparency requirements applicable to EU issuers listed in the EU may create a new standard for disclosure and thus have a spill-over effect on non-EU issuers or EU issuers listed outside the EU regardless of them not being directly covered by the SRD II.’
‘Many details need to be set by the legislator in the Member States. For example, what exactly will constitute a material transaction to be submitted to the vote of shareholders and what will not fall into that category? Another issue is to understand just how strictly the “comply or explain” doctrine will be applied’
Philippe Hoss, a partner at Elvinger Hoss Prussen
The Directive is in line with previous initiatives, but adds some requirements, Harles concludes. ’Changes are not radical, but will add complexity to the corporate governance. There might be additional litigation, which certainly is good for law firms, but not necessary for the companies concerned or their shareholders.’
For a clearer view on SRD II’s effectiveness, says Hoss, we will have to wait for its full implementation at a national level. ‘Many details need to be set by the legislator in the Member States. For example, what exactly will constitute a material transaction to be submitted to the vote of shareholders and what will not fall into that category? Another issue is to understand just how strictly the “comply or explain” doctrine will be applied.’
Guerritore concludes that overall, SRD II should create a change in the quality and quantity of stewardship, through greater awareness and greater expectations of investors and beneficiaries, and should ultimately contribute to the sustainability of EU companies.
‘SRD II should definitely increase transparency, which could lead to an improvement of the dialogue between issuers and their shareholders,’ he says. ‘Together with other legislative initiatives regarding long-term engagement and diversification of funding sources for issuers – such as the European long-term investment funds Regulation – it could lead to longer-term engagement and investments in listed companies.’