In their role as proxy voters, custodians must confront changing standards and legislation in countries in which they operate, says Martin Dickson

Helping clients vote on corporate governances issues is a core service for global custodians and one that is becoming increasingly important as pressure mounts on institutional investors to ensure that their voice is heard in important policy debates.

Over the past decade institutional investors in the US and the UK, and increasingly across continental Europe, have come to regard the existence of good corporate governance practices in companies as likely to be linked to good financial performance. Investors are therefore placing greater pressure on companies to ensure they meet acceptable standards in areas such as boardroom structure, division of responsibilities and executive pay.

Governments are imposing pressures of their own. In the UK, for example, a regulation that came into force on July 3 says pension fund trustees must declare in their annual statement whether they take account of social, environmental or ethical considerations in their investment policy. There is, however, no compulsion on the trustees to pursue such a policy.

For any institution with a wide spread of international interests, corporate governance can be a field of great complexity. First, different countries present a huge variety of governance norms and legal frameworks. Second, investors themselves can have markedly differing guidelines on what they regard as acceptable behaviour. Third, their willingness and ability to vote on these issues varies widely from country to country.

The US leads the voting league table. Some 83 per cent of outstanding shares there are voted in corporate governance ballots, compared with 71 to 80 per cent in Japan, 60 per cent in France, 58 per cent in Germany and a mere 39 per cent in the UK.

A significant factor in the high US total is the 1974 Employee Retirement Income Security Act (Erisa) which established federal fiduciary standards for private pension funds and made it mandatory for them to vote. Six years ago, Washington made clear that votes in foreign companies should be treated the same way as domestic US ones - a statement that has led to a rise in American investor voting activity around the world.

In the UK, the Labour government has hinted that it might consider legislative action to force fund managers to vote if they do not improve their performance, while a study last year by the Newbold committee, set up by the National Association of Pension Funds (NAPF), called for substantial changes to the current flawed and cumbersome voting system.

The role of the custodian in all this is not to take any voting policy decisions but to help clients vote their shares in as smooth and efficient a manner as possible. To do so, they work in close conjunction with proxy agents, companies which specialise in the field, to which they may devolve much of the mechanics of the process.

However, in many countries the task is made much harder by the long paper trail involved in voting. And the situation has been complicated by the growth of the external custody of pension fund assets over the past decade, since the custodian's involvement means there is an additional layer through which votes must pass before they reach the registrar.

In the UK, for example, custodians hold title to most of the securities owned by pension funds and are the entities registered with the company's registrar as the owner of the shares, with the legal right to vote at company meetings. A paper proxy card can therefore go through up to five organisations, including the custodian, before it reaches the individual responsible for deciding the investor's policy, and then back through the same chain before it gets to the registrar to be counted.

The system is cumbersome, slow, liable to mistakes and leaves no clear record of what has happened to the shares. Sheryl Muniz, a vice-president in London at Northern Trust, the large Chicago-headquartered custodian which runs a proxy voting service in 37 countries, says: "There are too many parties involved, it requires labour intensive work, and there is no clear audit trail. It is difficult for clients to monitor their investment managers and check whether they are obeying voting guidelines or they have voted at all."

The Newbold report pointed out that process can be further complicated because some custodians run pooled accounts into which they amalgamate all client holdings in a particular company. In these cases, it can be particularly hard for an individual fund within a pool to determine whether its shares have been voted - a position criticised by Newbold as "wholly unacceptable in a modern system of shareholder democracy".

In the UK, the custodian's burden should be lightened by enactment of the Electronic Communications Bill, which gained royal assent in May and gives legal standing to electronic signatures. This should mean the emergence of electronic voting services, reducing both the time and complexity of balloting, and leaving a clear audit trail. This, however, will only work as soon as all parts of the chain - from registrars to fund managers - are linked to an electronic network.

All these developments pose considerable challenges for custodians. First, they need to ensure their performance standards are as good as possible, especially where cumbersome paper trails are concerned. Second, they can do much to improve the system by maintaining discreet pressure for change in countries where the voting system is inadequate.

Third, they need to manage their costs carefully. Proxy voting is part of their core service to clients and may be provided at no extra charge. However, the increasing client focus on corporate governance issues threatens to push up the expense of the service.

This will be offset to some extent by the introduction of electronic voting, which is expected to reduce custodians' costs, but it is unclear whether the two trends will cancel one another out.</FONT>

State Street

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