Speech to the Association of British Insurers’ CEO Breakfast
28 November 2012, City of London
Thank you for inviting me to speak to you this morning.
I know that you are in many ways the oil in the country’s economic engine. From motor to household insurance, fire to flood protection, and pensions to life insurance – without you the engine would grind to a halt. You enable businesses and households to navigate risks. The economy to function. People to plan ahead.
I’m happy to explore this further in the questions and discussion but in my remarks now I’m going to focus on the role of financial services generally – of which you are a part - which has been at forefront of political and business debate, and its role in transforming the economy.
Last month, Ed Miliband set out our vision for One Nation Britain. A country:
· where everyone has a stake,
· where prosperity is fairly shared, and
· where we have a shared destiny, and a sense of shared endeavour.
When I told one of my colleagues I was planning to talk to you about building a One Nation financial services industry, he asked “isn’t that a contradiction in terms?”
Well, the crash of 2008/09 had its roots in part of the financial services sector. Fairly or unfairly, the reputation of the sector as a whole has been damaged as a result – even those of you that are long term investors.
But the health of this sector has huge implications for our economy overall. So I passionately believe that you are part of the solution for our businesses and individuals in meeting their future aspirations. In fact, as insurers, you have a particularly important role to play – both because you are consumer facing, and because of your influence on the behaviour of others, as long term investors.
There are, of course, big lessons for us all from the circumstances that precipitated the crash. We are wise to try to understand them. We will do this better when we approach the task – not in a spirit of accusation – but of honest reflection.
Labour is engaged in that process right now, as we come to terms with why we lost in 2010 and seek to develop a new platform that speaks to the challenges of Britain today.
So since I took up this role just over a year ago I have been having that conversation with you about the kind of economy we need, and about your role within it.
About how we can ensure that our financial services industry remains a beacon of global excellence and strength. And about how it can make a much bigger contribution to our economy overall.
With the shareholder spring we have seen encouraging signs of a different wind starting to blow. Much credit is due to those in your industry who have taken a lead, galvanised support, and showed this year that a different world is possible. In many ways it is the ABI and its members who have been leading the debate on corporate governance.
The proper exercise of shareholder responsibilities really matters. And it is in that context, this morning, that I want to focus on the takeover regime.
Times are tough right now.
When the Chancellor gets to his feet to give his Autumn Statement next week, he will do so against a very challenging economic context.
Despite the recent falls in the headline rate of unemployment, long term unemployment is up and just under one million young people are still out of work.
The Olympic bounce of the last quarter was welcome news, but the underlying weakness of the economy remains.
Austerity at home and renewed challenges abroad mean we are still bumping along the bottom.
Since the Spending Review we’ve had just 0.6% growth compared with over 3% growth in Germany and the US.
Without growth, it is harder to cut the deficit, however hard you cut spending.
It is all very well to say – rhetorically – that you can’t borrow your way out of a debt crisis. The Government is cutting its way into trouble faster than it can cut itself out with borrowing now £5bn higher than it was at the same time last year.
That is why Labour has been calling for a stimulus package, including using funds from the 4G mobile spectrum auction to build 100,000 affordable homes, implementing a temporary cut in VAT and a National Insurance break for micro businesses taking on extra workers.
You see, we are every bit as committed to bringing the public finances into balance. The difference lies not in the destination, but in the route chosen. And however you look at it, on this measure the
Government’s economic strategy is not working.
So getting growth going in the short term matters – it must be the priority.
But there are even bigger challenges about the nature of that growth over the long term:
· how we build an economy where our businesses and wealth creators can thrive in the context of seismic shifts in the global economy, and,
· how that can underpin a more prosperous and cohesive society at home in which the aspirations of the British people can be met.
The centre of gravity of the world economy is moving south and east. By 2025, emerging economies will account for more than half of global output. We must be ready for this.
At home, we must broaden the productive base of our economy, by sector and by region, as well as ensuring that productivity gains feed through to average earners. This has not been the case since 2003.
Building an economy that responds to these challenges is what Ed Miliband is talking about with his vision of One Nation Britain.
A stronger society, yes. But a stronger, more vibrant and successful economy too. An economy that builds value for the long term, creates and preserves our competitive edge, makes demands on all, includes all and rewards all.
Achieving these aims involves understanding how the rules of the game – how firms are governed and markets operate – affect the incentives for individuals, for firms and for collective behaviour.
That is why we accept the Kay Review principles and the overwhelming majority of its recommendations in relation to UK equity markets and long-term decision making.
It is why Ed Miliband commissioned former head of the Institute of Directors, Sir George Cox, to do our own review on the changes needed to enable a greater focus on the long term in corporate decision making, to build on the work of Professor Kay. Sir George will report early in the New Year.
It is why we fully support moves to abolish quarterly reporting and to make narrative reporting simpler, clearer and more focused, which Kay recommends too.
It is why we, like Kay, think companies should consult their major investors over major board appointments. I said earlier this year there was a strong case for changing Board nomination committees so they include shareholders.
It is why we would require fund managers to publish information on how they vote on all issues including remuneration, it is why we have signed up to the all the recommendations of the High Pay
Commission and would require employee representatives on remuneration committees.
And it is why Ed has raised concerns over the rules governing takeovers.
Takeovers are an integral part of a functioning market economy.
The external pressure applied on boards from the implicit or explicit threat of a takeover acts as an important discipline – although it is of course perfectly possible for existing shareholders to change an underperforming board, without changing the owners.
There are many good justifications for takeovers, like economies of scale or scope, greater efficiencies, and access to new markets. There are examples of takeovers which create long term value.
But there are plenty of examples of takeovers that did not fulfil their promise. Whatever the rights and wrongs of the ongoing HP-Autonomy dispute, all parties seem to agree that the takeover has not realised the value anticipated. The shadow of the RBS takeover of ABN Amro hangs over us all. Even where the strategic ‘fit’ is good, practical challenges of integrating one business into another remain.
In fact, though estimates vary, few who have looked at this issue systematically put the share of genuine takeover success stories above 50%.
This doesn’t mean that, as a matter of policy, we should take against takeovers. But it should lead us to question whether our takeover regime is serving the best interests of our economy, especially given it is far more permissive than most other equivalent jurisdictions.
And at this juncture, let me say something about foreign takeovers because this has been a source of some debate. By all means, let’s have the discussion but I think we should proceed with care here. The UK has benefited from inward investment – not just from the capital flows, but also from the flow of ideas.
There may be circumstances in relation to particular takeovers where genuine issues of national security arise from foreign ownership. But the existing law takes account of this.
In general, my instinct is not to make judgements about companies based on where they are headquartered, but based on what they can bring the UK economy, and on how they behave as corporate citizens when they are here.
For me, there are three sets of genuine questions for policy makers concerning takeovers.
First, is our takeover regime good for targets and bidders? Have we got the balance right between the pressures for change and any countervailing forces for stability?
In our economy there must be room enough for both organic and acquisitive growth. Particularly in newer markets, the journey to scale can resemble a winner-takes-all race as firms seek to be first in establishing a dominant position. Speed is king, and acquisition is simply faster than organic growth, even if it is more risky. So it is eat or be eaten, acquire or be acquired. And it is not always rational behaviour – fashions can draw us all in.
So we need to be careful that we are making sufficient demands on acquiring companies to explain themselves: how have they priced the deal? How they plan to realise the value which justifies the premium they are paying? I think this is somewhere we should all be more demanding – me as a legislator, and you as longer term shareholders.
And if it makes sense to do the deal, the benefits of the takeover should be clear to the bidder’s shareholders as well as the shareholders of the target company. They can, of course, already register their views. But takeovers that go sour can have such a significant impact on the stability and success of bidding companies that I am open to ideas about how the views of their shareholders can be given more weight.
And this is directly connected with the second set of questions. Who or what is driving the takeover bus? In whose interests is it being driven? And once it is on the road why does it seem so difficult to apply the brakes?
Expressing his concern about the role of arbitragers who bought shares in Cadbury once the takeover by Kraft was announced, Lord Mandelson put it this way:
“It is hard to ignore the fact that the fate of a company with a long history and many tens of thousands of employees was decided by people who had not owned the company a few weeks earlier, and probably had no intention of owning it a few weeks later.”
It was decided by those whose only interest was in the deal getting done. And they are not the only ones with misaligned incentives:
· There is the board of the acquiring company - running a bigger company some argue deserves a bigger salary; and
· Then there are the different advisors advising on the deal who face asymmetric incentives – like investment bankers fees who get fees when a deal goes through but not where there is no deal. So we need clearer distinctions between payments for advice, and any subsequent incentive payments for a successful outcome.
So transparency about incentives is a vital first step. But even with better rules on disclosure for takeovers, inherent uncertainties will remain.
As Ed said in his Conference speech, we want to end the situation where, once an offer period begins, short term speculators with no interest other than to make a quick buck can swoop in and distort decision making.
One option would be to limit the voting rights of shares acquired during the course of an offer period. Of course, short term speculators in the Kraft example found long term shareholders willing to sell – who, by their actions, showed similar indifference to the company’s future. So I am open to suggestions about how to resolve this conundrum.
One place where I think the law could and should be changed is in backing boards who feel that a takeover would be against the long term interests of the firm. Sir Roger Carr, the chairman of Cadbury at the time of the Kraft takeover, told the Kay Review that the board,
“...did not believe it was possible to reject a high bid that reflected full value for the business, even if they considered that the long term success of the company may best be achieved if it remained independent.”
In this case, the board thought that the bus must be driven over the edge of the cliff, simply because the bus must be driven over the edge of the cliff. The process had created its own unstoppable momentum.
In its response to Kay, the Government seems to think that the current law – section 172 of the Companies Act 2006 combined with the amended Takeover Code – is sufficient to protect against this. I am much less confident. Kraft-Cadbury shows the pressures Boards can come under, and so we would be wise to consider other ways to support their judgements in these circumstances.
So, there is, I believe, a strong case for more grit in the machine. Not necessarily to stop takeovers, but to stop the rush to takeover. Boards should be able to take a long term perspective, confident that the law will back them. And no bus should go over a cliff simply because it was heading that way.
All this links to the final set of big questions. Does the current regime best serve the broader public interest?
Here there is an issue about where ministerial discretion should be exercised, and a bigger issue about the impact of the regime on UK plc.
On the question of ministerial discretion, I am open to a discussion about the merits of a broader public interest test. But I should say that I start off as a sceptic. It seems to me that having a broad public interest test risks creating damaging uncertainty. It would also trigger political lobbying, and increase the risk that decisions to apply the test would be taken for reasons of short-term political
expediency, rather than based on a thorough investigation of the economic and industrial impacts beyond competition.
If I were the Business Secretary I, for one, would not look with joy at the prospect of intense political lobbying from all quarters every time a major takeover is in the offing. Ministers should not duck decisions where absolutely necessary but, in the main, responsibility for takeovers should rest with shareholders.
Under domestic and European law, Ministerial intervention is allowed in certain specified circumstances to protect the public interest. The 2002 Enterprise Act replaced a general public interest test with a regime that allows ministerial intervention in takeovers where they give rise to specified public interest concerns covering competition, press plurality and national security. In 2008, to permit the Lloyds/HBOS takeover, the Government introduced a fourth consideration related to financial stability.
I will say little about competition, save to note that this Government will shift responsibility for its application to the new Competition and Markets Authority in 2014. I will also remain silent on the issue of media plurality pending the report of Lord Justice Leveson tomorrow. And, as I have already said, ministers should always have the right of intervention where genuine issues of national security are at stake.
However, I do think we should be clear that Ministerial intervention under the financial stability category will only occur in the most exceptional of circumstances.
That category was introduced for very good reasons at an extraordinary time – to help prevent HBOS from collapsing. The Lloyds/HBOS takeover did lead to further consolidation in the sector and in the same, wholly exceptional circumstances I would have made the same decision. But we would not want this category to send the wrong signal.
One of the key issues for our banking system is to ensure that competition is effective and the industry works well for consumers. That’s why we have threatened to break up the banks if they don’t put their house in order. It is why we have called for a proper British Investment Bank. Going forward, despite the continued existence of the financial stability category which could potentially facilitate further consolidation in the banking sector, I find it hard to conceive of circumstances where we would want to intervene in support of further consolidation given the need for greater competition in the banking sector.
So there are the specific ‘public interest’ categories permitting Ministerial interference. But beyond this I am also particularly concerned about highly leveraged deals and the financial engineering which surrounds them. It seems to me that those who finance takeovers in this way must have a higher burden of explanation: what is their planned route to greater success? How likely is it that the company they are buying will perform so much better than before now that it is encumbered with so much debt?
Excessive debt – whether loaded onto a particular firm following a takeover or even being carried by a household – creates instability. It increases risk. It reduces the space for manoeuvre. It means that small fluctuations in income or expenditure can have disproportionate impacts. There is therefore a strong case for looking at whether our current system – not just the takeover rules – goes too far in encouraging debt over equity finance.
In addition to creating instability for the firms involved, there can also be real public costs to excessively leveraged deals – not least because takeovers which load the target company with debt have the effect of depriving the Exchequer of future tax revenues. I am open to ideas here, but one approach might to use excessive leverage as a trigger for additional scrutiny by the competition authorities.
I would also be receptive to other ideas that strengthen the process requirements for takeovers – particularly on disclosure and incentive transparency – to encourage more reflective and more rounded decision making.
Some have argued that to make takeovers more difficult risks undermining one of the key sources of competitive advantage for the City. It is a reason why we are able to attract inward investment, and why so many global companies are headquartered here. I hear that. But these arguments must be balanced with the interests of the economy overall, and the need for governance arrangements that best serve long term value creation. This is the key to a One Nation economy: more sustainable growth, in the interests – and to the benefit – of all.
Ultimately, this is what it means to be a service industry – an industry that exists not for the benefit of the participants in it, but to the benefit of others. This is not a woolly point about fairness. It is a hard boiled point about productivity in the context of a global economy. Here John Kay’s report should sound a warning signal to us all.
He is concerned about the impact of the structure of the financial services market with long chains of intermediation as well as the churning of stocks, and the impact this has on investor returns.
Each link in the chain of intermediation may only take a wafer slice but, the longer the chain the more these mount up, to the detriment of investors.
In essence, what he is saying is this: an industry that forgets it does not exist to serve itself is an industry sleepwalking towards its own demise. This is not a prediction, but it is a warning.
So as I wind up, let me be clear: our financial services industry is the envy of the world, and the City is rightly proud of its unique status and reputation. I am proud of it too. Globalisation has greatly increased the flow of money through London as the City services large parts of the global economy. But globalisation cuts both ways, rewarding the productive and punishing unproductive rent seeking. The Government has a role to play in doing what it can to preserve and enhance the status of the City.
But the industry has a far bigger responsibility – for and to itself. I started off by saying I believed in the possibility of a One Nation financial services industry. I end by restating this claim. But in between, I have raised a number of areas where I believe change is needed if this ambition is to be realised.
If we do not restore trust and confidence and ensure incentives are aligned to the interests of investors, savers and the wider economy, business will simply go elsewhere. Which is in none of our interests.