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Accounting, Auditing & Accountability Journal
Financial institutions, intangibles and corporate governance

John Holland
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John Holland, (2001),"Financial institutions, intangibles and corporate governance", Accounting, Auditing &
Accountability Journal, Vol. 14 Iss 4 pp. 497 - 529
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Financial institutions, Financial

institutions
intangibles and corporate
governance
John Holland 497
University of Glasgow, Glasgow, Scotland, UK
Keywords Financial institutions, Intangible assets, Information, Corporate governance
Abstract Explores the central role that private information on corporate intangibles plays in the
private corporate governance role of financial institutions (FIs). The institutional fund managers'
(FMs) private understanding of many qualitative or intellectual capital factors driving corporate
performance was the basis for wide-ranging corporate governance influence concerning financial
performance and conventional Cadbury-style corporate governance issues. This was primarily a
private, implicit corporate governance process by FIs and their FMs during good corporate
performance. Also reveals how the nature of FM corporate governance influence became more
interventionist with adverse changes in corporate performance factors, in FI-side influence
factors and in environmental circumstances. The qualitative intangible factors, especially board
and top management qualities, were central to this more proactive form of intervention. Finally,
discusses the case results within the research literature on the corporate governance role of FIs,
identifies new directions for research and discusses policy implications briefly.
Introduction and outline of the paper

The paper begins with an introduction to the field, a discussion of policy issues,
and a brief summary of the literature. Next, the research questions and research
methods are discussed. In the following section, problems with public corporate
governance and public disclosure mechanisms are outlined. These created fund
manager (FM) incentives to use private corporate governance and private
corporate disclosure mechanisms.
How FMs acquired private information from companies is then revealed,
and how this was used to form a knowledge advantage for use in both
investment and governance decisions. Much of the private meeting agenda
between companies and FMs focussed on qualitative information concerning
the intangible drivers of corporate performance and the corporate value-
creation process. Public information on financial performance and on Cadbury-
style corporate governance matters was well understood by the case FMs.
Private information on difficult-to-observe qualitative value-creation factors
was the means to extend this understanding. These qualitative factors involved
important intangible assets and were discussed within the context of the
prevailing debate on intellectual capital and intangibles.
The privately acquired information and knowledge on intangibles also
provided the means for FMs to exercise private corporate governance influence
over investee companies. The next section illustrates the private, implicit Accounting, Auditing &
Accountability Journal,
Vol. 14 No. 4, 2001, pp. 497-529.
Acknowledgements to CIMA for funding this research. # MCB University Press, 0951-3574
AAAJ corporate governance process of financial institutions (FIs), or more precisely
14,4 that of their FMs, during good corporate performance. Such influence by FMs
ranged from explicit influence on conventional corporate governance issues
such as the structure of the board, to more implicit influence on fundamental
accountability issues affecting wealth creation. A specific group of these
qualitative factors, such as the quality of management, coherence and
498 credibility of strategy, and the structure and functioning of the board, proved to
be convenient points for private and direct corporate governance influence by
FMs. The qualitative (factor) points of influence were also used to govern
indirectly many other qualitative factors determining corporate financial
performance. Thus influencing management succession was seen as a longer
term and more indirect means to change strategy and areas such as product
innovation and customer satisfaction.
How the private information on intangibles continued to play a central FM
corporate governance role as corporate performance declined and other adverse

events occurred is then explored. More specifically, the nature of the FM
governance process became more proactive and interventionist with declining
corporate performance, a deterioration in the company and institutional
relationship, in FM influence factors, and with the occurrence of adverse
external events. The qualitative intangible factors, especially board and top
management qualities, were central to this more proactive form of intervention.
Privately observed (or deduced) negative changes in these human capital
factors were important early signals of the potential for declining performance
and were a strong stimulus for subsequent FM action. Influencing the
composition or actively changing the board and top management (quality and
succession) were the means to change other qualitative value-creation factors
such as coherence of strategy, effectiveness of innovation, management quality
in senior and middle management teams, the quality of financial reports and
the functioning of board committees.
The paper therefore reveals forms of private FM corporate governance
behaviour which differed in key respects to that discussed in the literature on
public domain corporate governance. It provides a major expansion of the prior
work by Black and Coffee (1994), Holland (1995) and Stapledon (1996) on
private corporate governance by FMs.
In the penultimate section, the case results are discussed within the research
literature on the corporate governance role of financial institutions. Finally, the
policy implications of the model are discussed in terms of providing a much
clearer target for future corporate governance policy proposals involving
financial institutions. The paper is based on case interviews with 40 large UK
FM groups during 1997 to 2000.
Brief survey of relevant related work

Keasey and Wright (1993) outlined the two primary dimensions of corporate
governance. In terms of institutional shareholders, the first dimension concerns
active FM monitoring of management performance and ensuring
accountability to shareholders. FMs are expected to encourage actively the Financial
stewardship and accountability aspects of corporate governance. The second institutions
dimension emphasises how FM corporate governance (structures and
processes) needs to incorporate means for motivating managerial and board
behaviour towards issues of enterprise and of increasing the wealth of the
business. In this section we explore how academic work has investigated these
dimensions, and we also consider how they have played a role in the policy 499
debate. Special emphasis will be placed on the role of financial institutions in
such corporate governance activity.
Three research studies have investigated the private domain for corporate
governance. Black and Coffee (1994), Holland (1995, 1998a) and Stapledon
(1996) have investigated the governance role of UK FIs. All of these authors
interviewed (often the same) UK financial institutions during the early 1990s. In
the case of Black and Coffee, were the UK case data were used to draw
comparisons with the US system, and in the case of Stapledon, comparisons

were drawn with the Australian system. The work of Black and Coffee (1994),
Holland (1995) and Stapledon (1996), has provided the first real glimpse of how
the private FM influence process functioned and why both companies and
institutions preferred to operate in ``behind the scenes'' information exchange
and governance process. In a relatively unregulated environment, UK
intervention was not restricted to `èxit'' and there was a growing private
``voice'' element to institutional monitoring involving regular one-to-one
meetings between companies and institutions. Black and Coffee (1994) found
that, contrary to popular belief, UK FMs were more involved in corporate
governance than their US counterparts. All of these researchers identified a
higher level of FM intervention with problem companies, and all described the
formation of coalitions and the broader influence role of financial institutional
professional bodies.
Holland (1995, 1998b) also developed an explicit model of the private
influence or governance process by UK institutions. The research illustrated
FMs' role in the regular monitoring of good performing companies as well as
their role in major, but infrequent, interventions in poor performing companies.
The emphasis in Black and Coffee and Stapledon was on FM influence on
problem companies, whereas Holland (1995) identified implicit influence on
good performing companies as a major governance process. Holland (1995) also
highlighted the role of financial institution and company relations in providing a
bridge between the board and ``market for control'' mechanisms, and illustrated
FM use of corporate relations as the core of a combination of corporate
governance mechanisms. Holland (1997) investigated the corporate side to this
phenomenon and described how large UK companies communicated privately
with their institutional shareholders. This private disclosure process played a
central role in the FM's corporate governance process.
The impact of financial institutions on observable, public domain aspects of
corporate performance and behaviour such as private pre-disclosure impact,
use of R&D, and social behaviour, has been also been studied, inter alia, by
AAAJ Graves (1988), Graves and Waddock (1994), Allen (1993), Kochar and David
14,4 (1996), Bushee (1998), El-Gazzar (1998), Johnson and Greening (1999). For
example, El-Gazzar (1998) investigated the impact of the private pre-disclosure
advantage of institutions before earnings announcements. El-Gazzar found
that the higher the institutional holdings, the lower the market response to
earnings releases, thus suggesting such high ownership institutions were less
500 surprised than other investors. Bushee's (1998) research revealed that
managers were less likely to cut R&D to reverse an earnings decline when
institutional ownership was high, implying that (stable ownership) institutions
can reduce pressures for short termism. However, Bushee also found that if the
institutions had a very high level of ownership, a high share turnover and were
momentum traders, then companies had a higher probability of reducing R&D
expenditure to reverse an earnings decline.
Graves and Waddock (1994) found a significant, positive relationship
between corporate social performance (the attributes of which included

employee relations, environment, product, treatment of women and minorities,
and three others) and the number of institutions holding the shares of a
company, and a positive but insignificant relationship between social
performance and the percentage of shares held by institutions. Johnson and
Greening (1999) investigated the effects of institutional investor types and
governance devices on ``people'' (women, minorities, community, and employee
relations) and ``product quality'' (product and environment) dimensions of
corporate social performance (CSP). Ownership by pension funds was
positively related to both people and product quality dimensions of CSP, but
mutual fund and bank ownership were not. These results suggested that
ownership type was critical to corporate social behaviour and that pension
funds recognised the need to secure their legitimacy and maintain their
reputation by being active in these areas. However, banks, and mutuals (unit
trusts in the UK), and top management did not share such concerns. Smith
(1996) found a significant stock price reaction for successful company targeting
events by CalPERS, the Californian public employees pension fund, and a
significant negative reaction for unsuccessful events. Demsetz and Lehn (1985),
Schleifer and Vishny (1986), Leech and Leahy (1991) found that large external
shareholders were positively related to company performance and profitability.
However, Short and Keasey (1997, p. 45) argue that the broader evidence is
inconclusive. Short and Keasey (1995) conducted a UK study of the relationship
between corporate performance and institutional shareholdings. They point
out (in Short and Keasey, 1997, p. 46) that this relationship is complex and
difficult to disentangle. They found that when considered independent of other
ownership interests, institutional shareholders seem to have little impact on
corporate performance.
Implicit (and in some cases explicit) throughout the above research were the
presence and access advantages that ``relationship'' oriented FMs gained from
their stakes in their stable investees companies. They were presumed to
acquire information advantages which minimised surprises from many
associated corporate and environmental events, and they influenced areas such Financial
as attitudes to R&D, as well as to financial performance. In contrast to the institutions
above studies, the bulk of current theorising and empirical work has focused
primarily on public governance processes. It has emphasised publicly
observable events such as FM voting behaviour, unexpected and planned
board and managerial departures and appointments, public rebukes by FMs,
and public listings of poor performing companies by FMs. These public 501
corporate governance events have been investigated by a range of research
methods such as questionnaire surveys of say voting behaviour (Mallin, 1995),
or by market-based methods investigating the price impact of such public
events (e.g. Smith, 1996). In addition, the media have focused on newsworthy
public events such as an open dispute between the board and the institutions,
subsequent management departures and appointments, and public statements
on strategy changes.
This focus on public governance and controversial public events has

encouraged theorists and researchers to highlight a conflict model of company
and financial institutions relations. Jensen and Meckling (1976), Fama and
Jensen (1983) and Shleifer and Vishy (1997) have conceived the agency-
principal relationship between companies and institutions as an incomplete
contract that is unpredictable and does not cover all future contingencies.
There are many opportunities for managerial opportunism to be exercised
against shareholder wishes. Managers may pursue their self-interests by
abusing their power, boosting their pay and expending resources to boost their
prestige and power. Hence the problem is how to allocate efficiently residual
decision making and control rights to achieve the (shareholder) principal's
aims. There are similar principal-agency problems arising all along the chain of
accountability from employees, top management, the board, financial
institutional investors, pension fund trustees, and small savers. This paper
focuses on the company-institutional part of this chain. Berle and Means (1967)
have also developed the concept of ``separation of ownership and control''. The
public company, with its fragmented shareholder base, has weakened
shareholder control and increased managerial power. This has exacerbated the
principal agency problem, decreased investors' incentives to monitor, and
increased managerial opportunism. Such academic work and media attention
have created the strong impression that it is the public institution-company (FI-
Co) interactions that are the main governance activity of financial institutions.
Indeed, the strong normative stance of elements of this literature reflect the
view that governance should only be a public process. This position may well
have played a role in inhibiting research work on private corporate governance.
However, as indicated above, Marston (1993), Barker (1996), Gaved (1997), as
well as Black and Coffee (1994), Holland (1995), Stapledon (1996), Holland (1997,
1998), have all revealed that private company and institution interactions are a
systematic and pervasive feature of the UK financial system.
Much of the above academic work on corporate governance was stimulated
by the Cadbury report on corporate governance and the questions it raised
AAAJ about the role of institutional shareholders. The policy debate has continued in
14,4 the UK and the Hampel committee produced its final report in January 1998.
Many recommendations were made to codify the recommendations of the
Cadbury (HMSO, 1992) and Greenbury (HMSO, 1995) reports, to clarify the
roles and responsibilities of directors, executive and non-executive, and to
disclose information on executive remuneration. The Hampel report
502 (Committee on Corporate Governance, 1998) reinforced the central role of
shareholders in the corporate governance process and the importance of self-
regulation in the corporate governance process. It sought to highlight the
importance of corporate wealth creation and its wider roles in creating national
prosperity. Much of the Hampel recommendations for good practice were
incorporated in the London Stock Exchange listing rules in 1999.
This policy debate has occurred during a major change in the way
companies create value and in the nature of ownership of UK companies. There
have major changes in corporate value creation processes over the past decade.
These include the increasing significance of knowledge-intensive processes,
assets or intangibles in creating value within the enterprise, and within its
immediate network of corporate alliances, suppliers, distributors, and
customers (Stopford, 1997). The corporate value creation changes throughout
the 1990s created major information problems for the case FMs in their stock
valuation and selection, sectors, and portfolio-wide decisions. The changes in
corporate value creation and the resulting information asymmetries have also
increased the difficulties the case FMs face in their corporate governance role.
This has been especially the case with the dimension of governance (Keasey
and Wright, 1993) concerned with FMs understanding and motivating
managerial and board behaviour towards issues of enterprise and increasing
the wealth of the business. The post-war concentration of share ownership in
the hands of UK financial institutions has also created a more concentrated
form of institutional influence and control over UK companies (Holland, 1995).
This reached the point in 1998 where up to 75 per cent of major UK companies'
shares were held by institutions, with UK institutions owning about 60 per cent
of shares in FTSE 200 UK companies. The top 50 FMs dominated the
shareholder bases of FTSE 100 companies and constituted the bulk of their
core FMs. This has concentrated company and FM minds on each other and
increased the significance of their direct relationships and other forms of
private contact. This has also created a much clearer target for FM research
and for FM corporate governance influence. Given the dominance of the large
FIs in share ownership, the institutions have been effectively asked to play the
primary shareholder role in ensuring that companies were accountable for their
wealth creation activities, their decisions on corporate executive pay, and
corporate decisions on board structures. The increasing significance of pension
funds, insurance companies, unit trusts and investments, as the primary
vehicle for personal savings by the UK public, has increased the significance
both of UK company and fund performance. As a result it can be argued that
the institutions have a strong duty to protect the public interest and to govern Financial
companies on their behalf (Charkham and Simpson (1999, Ch. 21). institutions
The debate therefore continues about the role of institutions in corporate
governance both at academic and at policy-making levels. It reveals that the
monitoring and accountability dimension, and the enterprise dimension, of
corporate governance (Keasey and Wright, 1993) have both become central
tasks for FMs. The aim of this research project was to probe the private aspect 503
of the FM governance activity in greater depth both under normal co-operative
circumstances and under more unusual circumstances of conflict and
controversy.
Research methods
Given the nature of the research questions, a mixture of case study interviews
(with fund managers) and archival research methods was employed. The case
method was used to extend prior research on the private governance process
outlined in Holland (1995) and drew on prior work by Black and Coffee (1994),
and Stapledon (1996). The research was conducted in two stages and employed
different but complementary research methods in the two stages. Stage 1 of the
research involved collecting archival data on institutional intervention in UK
companies over the 1990s. The primary source was the quality press. The
Financial Times and other major newspapers were available on databases.
These newspapers were continuously revealing disputes between managers
and institutional shareholders. This stage provided data on topical cases to be
discussed in the stage 2 interviews. The author's 1993-1994 fund manager
interviews and 1993-1997 company interviews formed a further set of archival
data.
Stage 2 involved direct contact with 40 fund managers from different
institutions. Interviews were conducted with 40 fund managers in the period
from October 1997 to January 2001. The case FMs constituted 35 out of the 38
largest UK FMs (by managed and own funds) and included life insurance,
pension fund, and independent fund managers. A total 25 of these fund
managers had already been extensively interviewed by the author in the period
June 1993 to March 1994 (see Holland and Doran, 1998). The stage 2 research
method employed a semi-structured questionnaire approach when
interviewing fund managers. This stage built on prior work by Holland (1995)
in that a simple model of the influence process and changing circumstances
formed the basis of the semi-structured questions. An attempt was made to
interview some of the same fund managers so as to build on the prior Holland
(1995) work. A seven-stage approach was adopted to sifting through and
processing the case interview data (Easterby Smith et al., 1991). These stages
included case familiarisation, reflection on the contents, conceptualisation,
cataloguing of concepts, recoding, linking, and re-evaluation. During these
stages the interview responses of the various subjects were compared in order
to identify common themes and problems which indicated inter-subjective
understandings of the influence process.
AAAJ All of the case fund managers faced common problems with public
14,4 information sources and with public corporate governance mechanisms. They
also shared common external pressures to play an active role in corporate
governance. They all shared a common need to acquire a private information
and influence advantage for investment and for corporate governance
purposes. These common sets of problems were a major stimulus for all of the
504 case fund managers to pursue the following common themes, irrespective of
other institutional and FM variety such as institution type (insurance, pension
fund, unit trust) internal/external fund managers, quantitative vs qualitative
fund management style, or top-down dominant vs bottom-up dominant
investing style. The resulting case themes included the:
. limitations of public corporate governance mechanisms and the need for
active private FM corporate governance processes;
. nature of the private information agenda, including intellectual capital

and intangibles;
. how this information provided insights into the corporate value creation
process;
. role of private information on intellectual capital in diagnosing wealth-
creation problems and associated corporate governance problems;
. identification of qualitative factors suitable for the exercise of FM
corporate governance influence; and
. changing corporate circumstances and the associated changes in FM
corporate governance influence.
There was some variation in these themes across the FM cases. The cost and
benefits of intervention differed across the FMs. Size of FM and size of its stake
were major factors in the extent and frequency of intervention. The wider set of
themes linked the FM case data in a coherent form and provided a simplified
overview of much detailed and complex case data. They provided a reference
point for each FM's individual practice. They also emphasised the purposeful,
dynamic nature of this aspect of FI decision making and illustrated how the
case institutions actively sought to exploit unique private sources of
information on corporate intellectual capital in their corporate governance
decisions.
Public corporate governance, public information sources and their

limitations
In this section, problems with public corporate governance mechanisms are
outlined. These problems were further intensified by problems with public
disclosure by companies. These were exacerbated by an increasing intellectual
capital and intangibles component to share prices. The latter revealed the
significance of private qualitative information on corporate value creation
processes for both share valuation and corporate governance. Public sources of
information alone were unlikely to be satisfactory for these FM activities. Financial
These closely associated problems created incentives for FMs to seek private institutions
(or relationship) sources of information from companies as well as private
means of influence. The common channels for information and influence were
company relationships and regular private meetings with investee companies.
FM reasons for private corporate governance 505

The case FM reasons for preferring a private corporate governance process
included reasons to do with the limits of public corporate governance
mechanisms as well as the limitations of public domain information sources
(including financial reports, see ``Limitations of public information''). They also
reflected positive FM preferences for private disclosure and for the use of
private corporate governance mechanisms. The case FMs could resort to many
public forms of corporate governance pressure. These included checking public
documents to see if companies were conforming with the observable and more
formal aspects of the Cadbury, and subsequent Greenbury, and Hampel
reports. They also included media leaks, AGM votes on management
appointments and remuneration, and the sales of stock. However, Holland
(1995) revealed how the (1993-1994) case FMs made extensive use of private
influence processes to encourage good corporate governance and improved
financial performance.
The case FM reasons for this private process included the problems of using
public corporate governance mechanisms by themselves. Public information
was very limited and this restricted public corporate governance to a ``box-
ticking'' process. In addition, the public approaches were too blunt and too
crude a set of governance instruments for the case FMs. Many of the issues of
strategy and management quality were too complex to be reduced to an AGM
vote and were more efficiently dealt with through an in-depth private dialogue.
Public votes or public rebukes were too simple signals and their use could be
disadvantageous to the FMs' especially in terms of stock prices. Even on small
issues they inaccurately indicated that the FMs had lost confidence in the
management team and this could adversely affect stock prices. Furthermore,
the FMs did not wish to reveal their knowledge advantage or their investment
intentions by public questions or actions. Too active a public intervention could
also threaten the information and influence benefits of future private
interactions with companies. However, the public corporate governance
mechanisms were very important in two respects. First, they could be used to
buttress the private methods. The FMs required the public mechanisms to exist
because they could threaten to use them as a means of encouraging desirable
corporate change. The threat to vote on a contentious issue, to sell the stake, to
go public on a dispute, were all potent private threats. They created
opportunities to bargain, to deepen the private dialogue and to improve the
effectiveness of the private influence process before the FM was forced to take
public action. Second, if private influence failed, then the FMs could fall back
on the public mechanisms.
AAAJ Holland (1995) also reported on how the 1933-1994 case FMs identified many
14,4 positive reasons for private governance influence and these included:
. The knowledge advantage acquired from public sources such as the
financial report and from regular private contact meant that the FMs
could be more precise in their diagnosis of problems.
506 . The private influence processes were more protective of the share price
and avoided problems of release of price-sensitive information.
. The private process avoided public observation of controversial FM
access to private information, and to private learning opportunities.
. It alleviated managerial fears of FM control and interference because the
co-operative relationship context provided corporate opportunities to
counter-influence the core FMs,
. The UK law of libel and slander was a constraint on public comment, the
UK had a culture of secrecy and politeness, the speed and efficiency of
the private process, the ``clubby'' nature of the City,
. A preference on all parties for this private process rather than public
disputes which could damage the reputations of all concerned and
adversely affect company share prices and fund performance.
This hidden or private governance process was thought to maximise the value
addition benefits of normal co-operative interactions for case FMs. A ``behind-
the-scenes'' approach was also preferred in (rare) confrontational circumstances
to avoid adverse share price and fund performance outcomes. On occasion
these disputes broke out into the public domain and FM influence became open
and explicit.
Limitations of public information

The case FMs acquired much useful information from a purposeful search in
the public domain. This information could be company specific, industry or
economy wide. Public sources of information included company
announcements and financial results, as well as government announcements. It
also included information from sell side analysts, market makers, and broker's
sales desks. An important public source was the monthly estimate directory,
which provided aggregate earnings and forecasts about FTSE companies.
Security market reactions to corporate public announcements were of strong
interest to FM fund managers and in-house analysts as they used these price
changes as a barometer of corporate performance. The FM search of the public
domain was also supported by the professional information providers such as
Reuters and Bloombergs. The public information was useful to case FM staff in
enhancing their understanding of the firm and its markets, and it was an input
to their identification of ``cheap'' and `èxpensive'' shares and to asset allocation
decisions. This was central to their corporate governance role.
Fund managers faced a major problems in that all of the major information Financial
and data suppliers provided historic, ``rear mirror'' view, mainly public domain, institutions
information. The fundamental problem with these public sources was that the
information was perceived as already being in the price, with the price change
not necessarily indicating the nature of the event or information. In addition,
public sources such as financial reports and analyst reports were considered to
be limited in specific ways. 507
In particular, the case FMs perceived a wide range of limitations of statutory
financial statements and with the interim announcements which had a
structure based on the framework of published financial reports. (Similar views
were expressed by companies in Holland (1997, 1998c). Surprises could occur
with the earnings announcements, but investee companies experienced
considerable FM pressure to ensure this did not occur. This announcement
information was also fully assimilated by the FMs before the (post-
announcement) private meetings took place. As a result, the contents of the

financial statements were generally well known by the FMs before the annual
or semi-annual private company meetings and publication. In addition, the
financial report had become too complex, too large, and too cumbersome for
many users. The report was considered to be a source of information overload
for unsophisticated users, with some fund managers reacting against the sheer
scale and complexity of financial reports. The financial report was also tightly
constrained by ASB principles and by increasingly rigid GAAP. It had evolved
to serve multiple users and purposes and this created problems for investee
companies when they wished to tailor the financial report to the perceived
needs of institutional and other more specialised users. Finally, the financial
report was dominated by financial data and variables and did not provide
qualitative data on important areas such as management quality and strategy.
As a result, it was not an effective mechanism for disclosing information on
intangibles such as corporate knowledge assets and innovatory skills. Similar
problems were identified with other public disclosure mechanisms such as
AGMs and public announcements.
In the case of external analyst sources, these analysts had direct access to
company managers and also developed their special sources of information on
the economy and industry. The analyst was expected to `àdd value'' to these
sources by analysing them in an informed way. The enhanced information was
then released to fund manager clients in exchange for FM trading orders.
However, the case FMs identified problems with the quality of this analyst
information:
. Unless this research material was available to FMs on a confidential
``first call'' basis and was not immediately published then there was little
possibility that it had any value implications.
. The FMs perceived the analysts as having a bias towards sells or buys.
Their broker parent received commission from stock sales and the FMs
argued that many analysts ``put a spin'' on their research to encourage
AAAJ share transactions. In some cases the analysts were seen as selling
14,4 agents for the corporate finance arm of the larger investment banking
business.
. Only a select group of analysts could demonstrate special skills in
company- and industry-specific analysis. The vast bulk of them did not
have a high reputation with FMs.
508 . If there was an abundance of analyst research on certain large FTSE 100
companies and this was circulated around many FMs then much of the
public and quasi-public information would already be in the market
price.
Given these limitations, the collection and processing of public information, by
itself, was not expected to be useful in identifying cheap or expensive shares
and hence in boosting fund management performance. Public information was
too diffuse and not focussed enough for the FMs to use it in the influence of
corporate strategy and other corporate governance matters.
Public disclosure of board structure and changes, of executive remuneration,
of financial performance and of strategy provided an important means of
accountability to FM shareholders. Nevertheless, sole reliance on public
sources of information limited FMs, understanding of portfolio companies and
this constrained their ability to influence companies directly. This reliance
encouraged public means of accountability, especially `òutsider'' or `àrm's
length'' corporate governance by the case FMs. Such public forms of corporate
governance were indirect and focussed on ``box ticking'' or the implementation
of the observable and more formal aspects of the Cadbury, and subsequent
Greenbury, and Hampel reports. This approach also restricted FM influence to
public means such as media leaks, AGM and EGM votes and sales of stock.
Heavy reliance was also placed on the stock market disciplines of share price
performance feedback, and the market for corporate control (Holland, 1995).
Finally, we can note that as intangibles such as knowledge and innovation
have become an increasingly important part of corporate value, then this has
exacerbated the problem of how to disclose the value of these assets on the
balance sheet and how to explain how profits arise from such intangibles.
These problems of financial reporting of intangibles have increased the
information asymmetry between users and suppliers of equity risk capital. Lev
and Zarowin (1998) found that over the 20-year period from 1977 to 1997, there
was a decreasing share price informativeness of the numbers (earnings, cash
flow, and book value) in the financial reports. This decline was at its sharpest
in those companies that had increased their R&D intensity over this period.
They argued that this was because company financial reports had not captured
the changes in business over this period, especially the increasing role of
intellectual capital in innovation and added value.
The case FMs argued that they needed a special information edge for their
closely connected fund management and corporate governance roles, and this
was unlikely to be found with financial reports, public announcements, public
domain analyst reports on companies and other public sources. As a result, the Financial
limitations of public sources provided the FMs with strong incentives to institutions
develop private corporate sources of information.
Acquiring information on intangibles directly from companies and

its role in corporate governance
In this section, we see how these problems of limited public information 509
increased fund manager incentives to contact senior management teams
directly to discuss concrete and intangible sources of value and to observe
management qualities and their understanding of these value-creation issues.
The private dialogue was primarily conducted with good performing
companies and was undertaken in a spirit of co-operation between the company
and FM parties, and constituted an important form of implicit and explicit
corporate governance by the case FMs.
The financial reporting cycle created the opportunity for FMs to set up an
equivalent cycle of private, one-to-one meetings between companies and
financial institutions and therefore to acquire private information through this
means. The corporate reporting cycle was the normal stimulus for arranging
meetings on a regular annual or half-yearly basis. A key part of the private
agenda discussion involved the recent financial results and statements and a
continuing dialogue about corporate governance and other accountability
issues. Thus the financial report and measures such as EVA were public
domain means to establish a private corporate governance dialogue. The
financial reporting cycle also set in motion an equivalent corporate governance
cycle for FMs.
However, the FMs were primarily interested in qualitative, non-financial
factors, that played an important role in value creation. The case data revealed
the nature of this private information agenda concerning intellectual capital and
other qualitative matters. The FMs used the private meetings to identify the
major qualitative factors affecting value creation and corporate valuation. These
provided the conceptual base to explore how these factors interacted with each
other over time and hence how the value-creation process functioned in investee
companies. It was not possible to measure these qualitative factors in a precise
way, but identification of individual qualitative factors and their dynamic
interaction was a major step forward in understanding the role of intangibles in
value creation and hence in valuing the company. All of the qualitative factors
were benchmarked in some relative, subjective way against history, experience
or the competition, and thus a form of ``measurement'' was involved here.
This understanding of private qualitative information was combined with
public sources to create a knowledge advantage within fund management
teams, concerning individual portfolio companies, sectors, and the wider
portfolio. Creation of the knowledge advantage created a flexible asset that was
usable at all times during stock and portfolio decisions and allowed FMs to
exercise corporate governance influence in an informed way.
AAAJ The following two FM case quotes provide some insight into the private
14,4 agenda.
(1) FM Case 1
What is the information in the private agenda? We have two key information
requirements. We want to know the strength of the company cash flows. Therefore, we
want to know what the company has to play with going forward. Secondly, we wish to
510 know the strength of the management team. In other words we want to know who is
going to play with the cash resources. We are asking, are we comfortable with the asset
custodian, i.e. the management team? We want to know what their track record is, what
they have done in the past? Have they done the right things or not? What is their
strategy? There are major corporate governance issues here, what kind of team have
they assembled? Is there one manager ruling the roost or is there balance on the board.
Management ability and characteristics are very important. In the case of a top class
chief executive we will ascribe a premium to the company in this case. In contrast, AA at
XX plc is a destroyer of value of the company at present. Therefore, we can see that the
price has got a discount because of his leadership. We are also checking out some
individuals who we think are crooks and have got dodgy reputations and this causes a
downgrade in the share rating. In contrast, some gurus in some companies have the
opposite effect and increase the share rating. Incidentally, women chief executives are
seen to have an ability to up rate the share rating of the company. We also want to know
about management realism. Do they see the big picture or are they isolated in their own
little world? Management may say they have a fantastic growth strategy but we can see
this is not true. We speak to the buyers and the customers and the suppliers and they
have a different view and they tell us that margins are under pressure and there is no
growth here. We, therefore, hear the management story and try to put this into the larger
picture that we have picked up as fund managers. This includes the meetings with the
competitors and the suppliers and also from our macro view. Therefore, we are looking
for any contradictions or conflicts between the management view of the world and our
view of the world. This is what I mean about understanding management realism. Is
there any inconsistency in what they are trying to achieve given what they have to play
with in terms of cash resources and assets? Also, are there any inconsistencies in what
they are trying to do given the kind of macro world and competitive world they are in?
Can they turn things around in their favour? We are looking for a match between these
management qualities and the coherence of strategy. In terms of the coherence of
strategy, then we think the City has poorer understanding of strategy, especially that of
large, complex companies. Our framework for understanding strategies is not that good.
We do not see the depth nor the detail, or the subtlety of the strategy. We do not have a
house style for analysing strategy. We use things like Porters Five Forces and the
Boston Consulting Group framework for ideas. The problem with these is that the focus
is more on the output of strategy and they do not provide details on the strategic process.
We do have a problem here in understanding strategy with complex FTSE 100
companies. This is less true of smaller quoted but simpler companies.
(2) FM case 2
Why do we have one-on-one meetings with companies? Well, we prefer to not share our
special views or insights with other fund managers. The other advantage is we can
bring all of our fund manager decision makers together, especially those who are trading
and holding this company in their portfolio. We can also bring our decision makers
together with their key decision makers, such as their finance director and chief
executive. If we look at the agenda of the private meetings we find it is getting longer.
Our fund managers do one-on-one meetings to validate and support the investment
decision process. We find that corporate governance issues arising from Cadbury,
Greenbury and Hampel have expanded the agenda and we are now revising our
corporate governance questions and adding them to the list of questions of normal topics Financial
at the private meeting. Our fund manager does investment decisions and probes
information concerning investment decisions during the one-on-one meetings. Then I institutions
take up the corporate governance issues once these have been dealt with. For example,
there may be big board issues in terms of non-executive directors or chairman versus
chief executive. This does not lead us to sell the company shares. We try to use our
influence to change the corporate governance position in the company over some time.
The normal topics include a trading review of how trading is developing relative to our 511
expectations. We want to know how strategy is developing and any particular changes
that are being proposed and why this is occurring. We look very clearly at the finances.
We have clear expectations about the method of financing and the state of the balance
sheet and any radical changes in gearing or indeed in dividend policy then we want to
know quite a bit about this. This is really about us checking against our prior
expectations on these matters and seeing there has been no radical change. In our view a
lot of the above process depends upon our view of the credibility of management. So
much of the information coming through is subjective about strategy, about the
coherence of strategy, about innovation, about the value of brands, all these intangibles.
We are checking our expectations with those of management. If they are credible
managers then this improves our confidence in our own estimates of the future in terms
of return and risk faced by this company. The quality and credibility of management are
crucial in understanding the corporate governance issues and in influencing
management.
Intellectual capital and the unique private agenda: private sources and private
dialogue
The unique private information agenda consisted of, in part, a very different
information agenda to that employed for the public channels. In the previous
section we have seen that a key part of the private agenda was a dialogue about
public information sources, especially, quantitative financial information
sources such as the financial report. In contrast, the unique private agenda
included information on qualitative, non-financial company variables such as
``quality of management'', strategy and its coherence, investment and financing
plans, recent changes in these and in corporate succession and management
style. Information on competitors and the structure of competition was very
important.
The categories of qualitative private information identified in the FM cases
had many strong similarities to the ideas outlined by writers in the field of
intellectual capital. They were similar means to understand how value arose
within a company and to assess what potential there was for added value. Both
focused on difficult to measure, and difficult to value intangible assets.
Intellectual capital writers such as Brooking (1997), Edvinsson and Malone
(1997), Stewart (1997) and Sveiby (1997) have generally adopted a three-part
framework for understanding intellectual capital. These include ideas of
human capital, organisational capital or internal structural capital, and
customer or external structural capital as the three main components of
corporate intellectual capital. Human capital or employee competence is the
purposeful and ``thinking and doing'' capital and is the main source of corporate
responsiveness to new events, of problem solving, as well as of innovation and
invention of intangible and tangible assets. Organisational capital or internal
AAAJ structural capital includes hardware, software, databases, technologies,
14,4 concepts, inventions, patents, data, publications, strategy, structures and
systems, communication systems, procedures, manual and administrative
systems, which are owned by the company, are in existence 24 hours a day, and
can be reproduced and shared. Customer capital or external structural capital
includes the value of corporate relations with customers expressed through
512 their loyalty, and the power of company brands, trademarks, distribution
channels, advertising, reputation and image with customers.
The above classificatory schemes for intellectual capital were useful
guidelines for looking at the structure of the private qualitative agenda in the
FM cases. The FM case categories of private information and the above writers'
ideas of intellectual capital were similar in many respects. However, the
structure and content of the private agenda as induced from the FM case data
had its own character derived from the case study research approach. These
differences reveal the different perspective of the manager who has to create
value and the fund manager who has to assess value. For example, a major
difference lay in the top management and board emphasis of FMs and the
overall company emphasis of company management, intellectual capital
writers and researchers. The narrower FM focus arose from resource
limitations and from the need to gain a broad, overall valuation picture, rather
than a detailed ``how to manage'' picture.
In the case of FMs, the top management and board emphasis meant that
coherence of strategy especially relative to the competition and ``management
quality'', were key components of the private discussion on the nature of
human capital at the top of the company.
The FMs used the private meetings to probe strategy in depth. They were
interested in the board and top management's understanding of strategy, its
coherence and credibility, the degree of commitment and consensus on
strategy, and whether it made sense relative to the FMs' view and the views of
top-rated sell-side analysts and other external commentators. Informed probing
in this way was based on many prior contacts with the company and was an
important means to exercise influence implicitly. These probing questions
concerned prior strategic promises and performance promises, recent strategic
changes, benchmark comparison with competitors and the industry, corporate
innovation, ``good'' management practice, and problems with strategy.
At board level, ``management quality'' meant director skills, experience,
expertise, as well as some variety in these characteristics across the board. At
top and middle management level this meant management quality and
personality expressed as leadership, strategic vision, credibility, and trust.
Information on personalities of management also helped the case FMs assess
whether they could influence the management teams through a creative
dialogue or whether they would have to wait until the company needed help
before significant influence was possible. Thus the dominance of individuals
and cohesiveness of management teams were observed and assessed. Track
record and the personality characteristics of key managers, such as sense of
purpose, honesty, integrity, reputation were very important in establishing FM Financial
trust, and confidence in the company. These personality characteristics were institutions
assessed at the level of individuals, and management teams.
Recruitment, training and education of the whole workforce were not of central
interest to the fund managers unless it related to major expenditure decisions or to
capacity constraints caused by a lack of skilled personnel. However, the FMs were
interested in the broad way that human capital was being developed throughout 513
the company. Thus they probed top management's vision of human capital in
their workforce and industry and how this was being upgraded. The significance
of this aspect of human capital was thought to vary across companies and
industries, and so the FMs wish to know who were the critical staff in the
company, R&D or brand managers, and how were they retained, trained, and
exploited to create shareholder value. This limited view of human capital reflected
the fund managers' specific focus on corporate changes or characteristics that
were expected to create changes in the immediate share price.

Various forms of structural capital, both internal and external to the
company, were important to the FMs. Internal structural capital included:
. effectiveness of systems to improve, attract and incentivise human capital;
. effectiveness of innovation management processes, exploitation of R&D,
and high quality marketing and production capabilities;
. good management practices in the company such as those espoused by
writers such as Peters and Waterman (1982) and methods such as just-
in-time production, lean production, closely linked supply chains, and
high company commitment by management and other employees;
. the explicit nature and high quality of new product development;
. ``good practice'' in risk management, both financial and product-market
business risks;
. the quality of training plans for all staff and general human resource
development in the company;
Internal structural capital also included corporate governance structures.
In contrast to the complexity of internal structural capital as seen by FMs,
the FMs' interest in `èxternal structural capital'' was very similar to that
proposed in the intellectual capital literature. The fund managers were very
interested in how the companies managed their relations with customers and
suppliers and perceived customer and supplier satisfaction. They wished to
know how the company exploited customer loyalty, existing products and
services, the strength of company brands, trademarks, distribution channels,
advertising, reputation and image with customers. They wished to understand
the relative quality and effectiveness of these external intangible assets. They
were very interested in how these market-based intangibles created a
competitive position in the marketplace and how this was expected to boost
market share and contribute to shareholder value.
AAAJ In addition, relationships with core fund managers and banks were an
14,4 important indicator of corporate reputation and credibility in financial markets.
Ability to communicate in a credible way to suppliers of equity and debt capital
and to intermediaries such as corporate brokers was seen as an important
corporate asset.
The case FMs expended considerable resources to understand the corporate
514 value-creation process. The regular contact with many portfolio companies
meant that the case FMs were in a unique position to learn how elements of
structural capital such as strategy and board structure, the character of
innovation and various management practices, all interacted with elements of
human capital such as management quality, to contribute to good financial
performance in different ways across companies and industries. They could
also observe the collective effect of these variables on joint effect on financial
performance and share prices. This provided the means for FMs to develop a
knowledge advantage concerning these qualitative factors and variables and

their price impact.
Private FM monitoring of intangibles, learning and impact influence

The private relationship access and information acquisition outlined above
provided the means for FMs to exercise private corporate governance influence
over investee companies. This influence referred to situations where the
company was performing well. More specifically, understanding the
qualitative factors driving corporate performance in the corporate value-
creation process created the capability to conduct an informed FM corporate
governance process. The very fact that FMs asked many probing questions of
their investee companies on a regular basis, that they could observe
management at close quarters, and that this was repeated across at least 20
well-informed FMs, meant that a continuous, implicit corporate governance
process was in place. Such influence by FMs ranged from explicit influence on
conventional corporate governance issues such as the structure of the board, to
more implicit influence on fundamental accountability issues affecting wealth
creation (implicit during good corporate performance only). FM influence on
conventional corporate governance issues were informed by the prevailing
Hampel-style debate, the need for corporate compliance, and corporate
performance issues. Influence on shareholder wealth issues were informed by
the FMs' inside knowledge of the wealth-creation process, as well as corporate
performance and circumstances. Both were recognised as a broader corporate
governance agenda by Hampel, and this view reflected FM practice.
The case FMs also used their access to private qualitative information to
gain a more balanced picture of a company based on the past (past value
creation and financial performance, financial policy, accounting changes,
corporate governance history, management experience and track record), the
present ( current value creation and results, strategic changes, communication
skills), and the future (management vision and promises concerning value
creation and performance, perceptions of risks and challenges, match between
management quality and contingencies). The FMs' aim was to use the balanced Financial
picture based on private information to understand how the company could institutions
continue to improve shareholder wealth and to assess the implications of
renewed and developed intellectual capital for the share price. This FM
approach was similar to that employed by Skandia (1998).
The stock market reaction to corporate performance arising from these
human capital and structural capital interactions was a key stimulus for FMs' 515
corporate governance feedback to their investee firm. This involved influence
on structural capital factors and human capital factors. The knowledge
advantage was central to diagnosis of problems and to targeting of FM
influence. A specific group of these qualitative factors was the main corporate
governance influence point. Thus factors such as the quality of management
proved to be convenient points for private and direct corporate governance
influence by FMs. These qualitative (factor) points of influence were also used
to govern indirectly many of the other qualitative factors determining

corporate financial performance. The nature of corporate strategy was critical
to the case FMs' understanding of how both tangible and intangible assets
were co-ordinated in a purposeful way to create value. An extensive private
dialogue on these matters was the means for the FMs to influence directly
strategy and to influence indirectly the exploitation of other intangible assets
such as the effectiveness of innovation processes, or the state of customer
relations.
FMs did not necessarily seek or use all of the qualitative information
accessible from private meetings. Their primary focus was on valuation and
their investment decisions and this determined many of their information
demands in private. Each case FM went into the company meetings with their
own tailored list of questions. These covered a subset of the above private
agenda as the FM sought to explore its specific concerns on a company's share
value and to understand which current issues were impinging on the
company's share price value during good corporate performance. Corporate
governance and accountability issues were secondary to the valuation and
investment issues unless governance issues affected share value and
investment decisions in some way. However, the learning process concerning
these qualitative factors was central to their routine and special issue corporate
governance role.
Corporate governance structures as internal structural capital

A key focus for the case FMs concerning `ìnternal structural capital'' was on
many corporate governance, board and top management issues. At board level
this included a clear board structure, a board with real power over top
management, and unified board showing unity of purpose and direction. This
also included a high quality strategic review decision process which produced a
coherent and rational strategy. At top management level the focus was on the
stability of senior management, an agreed succession policy, and a clear
organisation and divisional structure.
AAAJ In general FMs were interested in the effectiveness of systems to improve,
14,4 incentivise, attract, and maintain human capital at top and middle management
and at board level. Training systems for managers and (more recently) for
board members were of growing interest. This meant that the FMs were
primarily interested in structural capital and its role in improving human
capital at top and middle management levels. Again, this was a much more
516 limited and focussed agenda compared to that proposed in the intellectual
capital literature.
In addition, Cadbury-, Greenbury- and Hampel-style corporate governance
issues were a key part of the private agenda concerning internal structural
capital. This included issues such as the separation of chairman and chief
executive roles, the number and quality of non-executive directors, and the
contracts of executive directors. Succession plans for chief executive, chairman,
finance director and other key managers and directors were discussed to assess
how they might affect management quality and other human capital issues.
The case FMs probed to see if relevant board committees existed and
functioned correctly, whether the remuneration committee consisted of non-
executive directors only, that there was an appropriate proportion of non-
executive directors on the board, and that reappointment of directors (executive
directors and non-executive directors) was not automatic. They were also
interested to know if the number of board meetings had increased to Cadbury-
recommended levels. Such conformity to good practice guides created strategic
options for future influence for the case FMs.
An active dialogue was a means to influence the company on these matters.
It was also an indirect means to influence the strategic direction of the investee
companies and their expected financial performance. A key connection
identified by the case FMs was that corporate governance mechanisms such as
Cadbury-style board structures could play a central role in identifying,
encouraging, and supporting good quality managers. The case FMs also used
the private meetings to observe if senior executives were implementing the full
spirit and substance of the (more traditional) Cadbury and Greenbury corporate
governance proposals or were adopting a superficial approach to the reforms.
This form of probing went far beyond ``box ticking''. It allowed the case FMs to
assess whether matters such as the separation of chief executive duties and
chairman duties had been implemented in a token manner by a powerful
executive or had been implemented so that the two roles were distinct,
complementary and substantive. If it was the latter then this created more
flexible points of future influence for case FMs.
These case data therefore reveal that implementing Cadbury and Hampel
were important means for the case FMs to influence corporate performance to
reflect their shareholder interests and to create new influence options. Smith
(1996) has studied the effect of shareholder activism on corporate governance
and its impact on shareholder wealth. He focussed on one very large US FM,
CalPERS, the Californian public employees pension fund. He found a
significant stock price reaction for successful company targeting events by
CalPERS and a significant negative reaction for unsuccessful events. Demsetz Financial
and Lehn (1985), Schleifer and Vishny (1986), Leech and Leahy (1991) found institutions
that large external shareholders were positively related to company
performance and profitability. This US evidence and the existence of an active
UK influence process revealed the opportunities for the UK Hampel report in
1998 and its successors in encouraging FM influence in the interests of
improved corporate governance and in boosting financial performance at the 517
same time. The core group of FMs were connected through an active market for
information involving analysts, the financial press and their own direct
contacts with companies. The core group is therefore likely to be pursuing
much the same performance agenda with a particular company and reflecting
the wider market consensus and diagnosis of corporate problems and
strengths. As a result, the core group of UK FMs may have a similar effect on
UK company performance as the large US shareholders through their regular
probing and implicit influence.

The case FMs also identified some formal corporate governance areas, such
as executive remuneration, where they were careful and sometimes avoided
influencing management. The case FMs provided a range of reasons why they
preferred to avoid interfering in board or top management decisions on
remuneration. They argued that they had appointed the board and top
management as their agents to make a whole host of managerial decisions
including pay. To interfere would undermine ``management's right to manage''
and could involve the FMs in detailed managerial decisions outside their
perceived area of competence. It appeared that the threat to their private
company relationship advantages was a major issue in limiting the scope of
FM interference. In addition, the incremental costs of high pay or perks were
seen as small relative to the larger shareholder wealth gain acquired from an
effective top management team. These barriers to FM influence were quickly
removed if poor corporate performance became a major issue. In some cases,
other barriers to interference included the FM's need to secure pension fund
management business from the corporate sector and the similarity of their own
executive remuneration packages. Despite these case FM comments, it may
prove difficult in the political climate of the new millennium for the case FMs to
maintain the view that their corporate agents can determine the size and
structure of their own remuneration.
Differences between the qualitative factors in terms of information access and

influence possibilities
There was some variation in terms of direct FM access to information on a
specific group of qualitative factors (for corporate value creation), and in terms
of FM ability to influence these factors directly or indirectly. In the more
specific case of board and top management quality, these human capital factors
were important in four ways. First, the board and top management were the
primary contact or meeting point for institutional investors. Second, the board
and top management were the primary source of information about the larger
AAAJ set of human capital and internal and external structural capital factors. The
14,4 case FMs could therefore gain unique direct access to information on these
clusters of variables. They could either directly ask questions about these
factors or they could directly observe the variables in action. Third, this direct
contact meant that the FMs also chose these variables as the first point at
which they sought to influence the company. Thus a specific group of these
518 qualitative factors, such as the quality of management, board and top
management pay schemes, coherence and credibility of strategy, structure and
functioning of the board, and the quality of public and private disclosure
mechanisms, proved to be convenient points for private and direct corporate
governance influence by FMs. The choice of which of these factors or issues to
influence depended on unique corporate circumstances and macro conditions.
Thus pay was ignored by FMs when financial performance was good but could
be a dominant issues when financial performance faltered.
The importance of managerial human capital as the pivotal influence point

is revealed in the following FM case 3 quote:
Corporate governance is, firstly, about having good management to run the company.
Therefore, corporate governance is a performance and investment issue. However, large
companies are difficult to influence directly. We, therefore, try a more diplomatic approach
and try to get things in place early. For example, we try to get non-executives in place one to
two years before we may need to exercise influence on them. We, therefore, cajole large
companies to adopt good corporate governance practice. This means that if things go badly
then the non-executives are there so that they will be useful for us to use as a medium for
influence when the chief executive and chairman are less willing to talk to us. We also try to
influence management succession so that mangers with the right qualities are in place and
are also willing to listen to us and to talk to us.
Fourth, the private meetings were one means to acquire information on other
qualitative factors such as external structural factors. However, FMs relied
more on external analysts and commercial surveys as their first source of
public or private information on these external structural capital variables. The
sell-side analysts had a strong focus on earnings-related variables such
customer attitudes, brand strength, and competitive position. These variables
were closer in impact to immediate earnings changes and a small group of high
quality sell-side analysts often had specialist expertise here. Commercial
survey groups such as MORI also collected information on how consumers
viewed the favourability of services and products in certain industries, and
companies. Specialist media companies also surveyed public attitudes to
brands and to company reputations. These surveys were often tailored to
corporate, analyst or FM needs. The FMs used analyst information and survey
information, when available, as the basis to probe these areas in greater depth
during their private meetings with companies. In contrast, the FMs could
generate their own good quality qualitative information on other external
structural capital factors such as relationships with core FMs and the
effectiveness of company disclosure mechanisms. Their direct and repeated
experience of these factors proved a useful sources of information. Survey data
were also available here from bodies such as the Investor Relations Society.
In the case of a small group of human capital (company wide) and internal Financial
structural capital factors, the FMs faced difficulties in acquiring inside institutions
information on these factors. They often used proxies or surrogates for these
variables. For example, good foreign exchange risk management could be used
as a proxy for overall risk management. The arrival of a new senior executive
or board member with strong brand management skills could be used as a
proxy for improvements in this area in the company. The poorer quality 519
information and access to these external structural capital factors and internal
structural capital factors affected their ability to influence such factors. As a
result, a subset of the qualitative and direct points of influence were also used
to govern indirectly many of the other qualitative factors determining
corporate financial performance. In particular, changing the current
management team or influencing management succession was seen as a longer
term and more indirect means to change risk management, product innovation
and customer satisfaction. Again, the particular target for change varied with
circumstances.
The significance of the above qualitative value creation factors varied with:
. unique corporate circumstance such as the sudden loss of a key
executive;
. the nature of the industry, with R&D and product innovation more
important in pharmaceuticals than in the packaging industry, and brand
management more important in consumer retail industries;
. the size and maturity of the company provided economies of scale in
critical intangibles such as R&D or brand management, and in terms of
accumulated knowledge assets;
. the perceived stage in the economic cycle with management track record
in dealing with previous booms or recession becoming very important.
As a result, the case FMs laid different emphasis on parts of the intellectual
capital agenda according to unique corporate circumstance, industry and stage
in the economic cycle. They also varied their view of what were the important
linkages through the above value-creation process. This understanding, in
turn, created the capability to exercise influence over many connected human
capital and internal and external structural capital factors.
In all of the cases above, the case FMs used some form of historic or
competitor benchmark as reference point to assess the significance of the
qualitative information from the private meetings. This benchmarking was
straightforward for the financial performance for the company and its sector.
Benchmarking was also possible using corporate governance standards and
good practice guidance for voluntary disclosure. The FMs also had formal
records of previous meetings with the companies on how the qualitative factors
had played a role in producing this performance. They also had a record of
previous promises made and the extent to which they were kept. As a result,
this cumulative learning proved to be a useful benchmark for areas such as
AAAJ management quality, coherence of strategy, and track record. Thus some form
14,4 of ``measurement'' of these qualitative factors was being conducted over time
and the FMs were not faced with a vague discussion of intangibles in which
they had to start at the beginning at every meeting.
Changes in intangibles and variation in the FM influence and

520 governance process
The corporate governance process outlined in the previous section was
primarily a private, implicit corporate governance process by financial
institutions (FMs) during good corporate performance. Understanding the
nature of intangibles and their role in valuation was critical to this more co-
operative form of corporate governance. However, changes occurred in the
qualitative and intangible corporate performance factors, in FM-side influence
factors and in environmental circumstances. As a result the nature of corporate
governance by FMs changed.

Holland (1995) revealed that there were five major stages of changing FM
influence. This was confirmed by the new 1997-2001 FM case data. The five
stages were:
(1) Good corporate performance ± good FM and company relations ±
implicit FM influence.
(2) Company asks for help or advice ± adequate corporate performance ±
functioning FM and company relations ± increasing private FM
influence.
(3) Company problems ± FM-company relations declining ± strong private
explicit FM influence ± FMs give management time.
(4) Company crisis ± poor or disrupted FM-company relations ± FM or FMs
demand change ± private and public conflict.
(5) Breakdown of relations ± potential for takeover ± stimulated by FMs
and by allies in wider City influence network ± private and public
conflict.
In its simplest form, the five stage model above described the changing nature
of FM influence with changing corporate circumstances. However, the
corporate progress through these stages was not inevitable and it was
reversible. Most companies experiencing stages 2 and 3 found a way out these
problems through their own efforts or through the help and influence of their
core FMs. Indeed, most case FMs stated that their aim was to influence a
company so that it did not move to stages 3, 4, and 5. If it did, their aim was to
move it back to 1 and 2 as soon as possible.
The following FM case 4 quote reveals the implicit nature of the model in
many of the case FMs:
Influencing companies and collecting information during private meetings is an art and not a
science. As fund managers we do this based on a mixture of experience and intuition. We do it
in teams of fund managers and in-house analysts. Our understanding of what we are doing is
not always explicit and is often reflected in our behaviour in the meetings rather than in some Financial
clear-cut policy. It is difficult for us to explain this process. There is not much in the way of
theory used by fund managers. If you were to ask my colleagues how they go about this institutions
process or whether they have a theory guiding their actions, they wouldn't have much to say.
We are much more people of action than reflection. However, the point is that we do influence
companies and we do collect private information from companies in a fairly persistent if not
terribly systematic way. We do prepare questions beforehand, we do question the
management carefully, and we do analyse the meetings afterwards. But the whole process in 521
fairly flexible and the degree of pressure we exert depends on the circumstances surrounding
the meeting.
The 1997-2001 FM case data also revealed that the corporate governance stages
were the outcome of a complex change process that involved many factors.
These included major (single, simultaneous or combined) negative changes in
the wider set of qualitative corporate value-creation factors (B) already
discussed. They also included changes in FM situational factors affecting FM
influence capability (C), and in corporate performance output factors (X).

External change factors also changed FM perceptions of the significance of the
above changes and encouraged FM active influence and intervention. Finally, a
complex cost-benefit calculation was employed by the case FMs concerning the
consequences of intervention or non-intervention. FM active intervention in
stages 3, 4 and 5 normally required the existence of all of these conditions. This
was a major reason why public intervention by the FMs was relatively rare and
hence why private corporate governance by FMs was the dominant process.
The primary corporate performance measures (X) used by the case FMs
included share price, profits, cash flows, and other financial performance
measures such as EVA. Negative changes here, observed publicly, were a
dominant stimulus to FM influence and intervention. However, in sections 4
and 5, we have also seen how the case FMs sought to understand how these
public performance measures (X) might change by observing or discussing (in
private) fundamental corporate performance factors (B) such as management
quality, strategy, risk management, innovation, and competition. As a result,
changes in the qualitative intangible factors (B), especially board and top
management qualities, were central to the more proactive form of corporate
governance intervention observed in stages 2 to 5. All of these intangible (B)
factors provided private information (early signals based on private
observation, deduction, or disclosure) on likely or actual, negative and positive
changes in each factor in the value-creation process and in key links in the
process. These private observations of negative changes in the B factors
provided early warning of potentially negative changes or of declining
performance (X) and were a strong stimulus for subsequent FM action. They
therefore provided early signals to FMs whether to exercise implicit or more
explicit corporate governance influence over companies. High quality and
effectiveness in all of these value creation (B) factors constituted positive
company-side factors favouring (implicit) FM influence. A decline in these
company value-creation factors encouraged explicit FM influence and perhaps
intervention.
AAAJ Case FM 5 reveals how this information might arise:
14,4 There is no regimented way of understanding these changes. If the quality of management
declines for some reason, for example, a top manager changes or leaves and there is a very
limited management resource. This is a big change. Let us just assume it is a competitive
market. How do we interpret this qualitative information about the change in senior
management? Well, it increases the probability of screwing up in the company. It increases
the chances that growth will not be delivered. There is a chance that the company will lose
522 market share. There is a possibility it will turn the business in the wrong direction and
growth will decline. Now we can look at these guesses and say, well we think that it looks like
profits will start to decline and cash flows will decline and value will decline. This is a sort of
a rational guess in a risky world using subjective information. It is the best we can do. Once
we have made this guess we can then decide what to do in terms of influencing the company
or changing our stake.
Influencing the composition or actively changing the board and top

management (quality and succession) were the dominant proactive means to
change other qualitative value creation factors such as coherence of strategy,

effectiveness of innovation, management quality in senior and middle
management teams, the quality of financial reports and the functioning of
board committees. The FMs recognised that they had to work through the
board and top management (human capital) to change these and other
qualitative factors affecting financial performance. Thus in stages 2 and 3 these
were the targets for ever-increasing influence. However, in stages 4 and 5,
replacing an obstructive board or management was seen as a more direct, quick
and cheap way of changing these fundamental performance factors. This was
only feasible if competent new management teams were available to replace the
incumbents. As a result, management quality and succession were the central
focus of FM influence as corporate circumstances changed. As corporate
circumstances changed from co-operative relations, to corporate need, to
adverse circumstance, to hostile relations, then the nature of the influence and
advice on management and management succession and change became more
proactive, forceful and explicit. Edgecliffe-Johnson (1998), and Farrelly (1998),
provide a short discussion of how FMs used management changes, and Dayha
(1997) reveals the stock market impact of management change. This level of
sophisticated influence concerning management quality and succession was
dependent on long FM experience and knowledge of managers over their
careers with many investee companies. The FMs argued that this influence
focus meant that ``the market for top corporate executives and directors'' was
also a private market over which they exercised considerable influence.
The case FMs were also very interested in the (qualitative) FM-side
situational (C) factors which increased FM (structural) power to intervene, and
favoured successful FM influence and intervention. These FM influence (C)
factors included, amongst others, an established company relationship, a high
FM knowledge of a company, and a good ability to diagnose problems. The
core FMs' investment policy was also important. A non-indexer FM, with high
exposure to certain companies, was likely to adopt a proactive stance to these
companies. An indexer FM was likely to the set of weak companies to
encourage the others in the large portfolio. The size of core FMs relative to Financial
company and the size of stake also altered influence possibilities. Negative institutions
changes in FM influence factors, observed or deduced privately, were also a
major stimulus to FM influence and intervention. Such negative changes in FM
influence factors (C) were often associated with changes in corporate side value
creation factors (B above) and hence with an expected decline in corporate
performance. 523
The likelihood of FM power being exercised also depended on many external
issues and events. The external events affecting a company included, inter alia,
a change in the industry, in the economy, or in the regulatory structure. Thus
the late 1990s fashion for Internet stocks meant that case FMs probed how
companies were going to alter their value-creation process to reflect this radical
technological shift. The case FMs analysed how major macro economic
changes such as recession or boom were having, or might have, an impact on
the intangibles at the heart of the corporate value-creation process and hence on
stock market price expectations. These expectations were critical to decisions
to intervene or not. In general, poor performing companies (relative to the
sector and market) which had gradually moved from stage 1 to 3 or 4, were
given time and helped back to stage 1. This was more likely when the overall
economy was performing well and the company was carried up with the rest of
the stock market. When economic times became harsh the FM attitudes
hardened as a company progressed to stages 3 and 4. FMs had a stronger
tendency to intervene or to go further and precipitate a crisis under these macro
conditions.
These external events alone, or combined with internal events such as
changes in key intangibles, were often the key to the move to proactive and
more collective influence processes in stages 3, 4 and 5. Weak financial
performance and below-average share price (X) were often not enough.
Companies could fend off FMs with alibis, their need for time, and the
argument that ``you appointed us''. But events could impact on the share price
and much strengthen FMs' hand to construct crisis or to heighten a crisis set up
by events. Thus most core FMs waited for a trigger or stimulus to act. This
increased their ``circumstances power'' to be able to act in stages 3, 4 and 5.
Major internal company or external events could precipitate lead FM action or
be used by the core FMs to generate a crisis and to formulate a coalition. This
was a feature of stages 3, 4 and 5. The idea was to act before X became so bad
that influence and intervention was pointless, and before B and perhaps C
became so negative that private influence and intervention became difficult, if
not impossible. Unexpected company-based problems with key intangibles
within the value-creation process, such as a product quality problem or a
sudden resignation of a top manager or board member, could combine with
these external events and stimulate a possible or actual crisis. This radically
altered the FM influence process. The FMs could then target top management
and strategy as the main intangibles route to change.
AAAJ Discussion and further research
14,4 Theorist, such as Jensen and Meckling (1976), Fama and Jensen (1983) and
Shleifer and Vishy (1997) have highlighted a conflict model of company and
financial institution relations. These agency-principal relationships have been
viewed as incomplete contracts which are unpredictable and do not cover all
future contingencies. The answer to this problem in the principal agency part
524 of the contracting literature is for shareholder principals to incur agency costs
(in an efficient and effective manner) to minimise opportunistic behaviour by
corporate agents. This can be done by aligning management incentive schemes
with shareholder needs, by incurring monitoring costs, and by the use of
takeover mechanisms. In contrast, in this research, the incomplete contract has
been buttressed by implicit relationships between companies and financial
institutions, or more precisely between the fund managers and corporate
managers and their joint investment in their shared human capital. This was
primarily a means of cooperation and mutual exchange of information and

influence benefits between the two parties rather than a focus for conflict.
During periods of good or acceptable corporate performance, relationships
provided a shared structure for both parties to respond to uncertain future
contingencies in a mutually beneficial way. The common (human capital)
interests of both parties provided the incentive and low cost means for financial
institutions to monitor companies, to overcome the information asymmetry, to
seek to align management incentive schemes with shareholders needs, and to
generally influence company decisions in a manner desired by fund managers
acting as the beneficial owners or as the agents of other beneficial owners such
as pension fund trustees. Thus implicit contracting in the private domain
through ``relationships'' and dialogue-based influence over corporate human
capital was the key means to overcome the incomplete contracting problem,
and to exercise further influence over an extended range of intangibles
involved in value creation. In the bulk of good performing companies implicit
contracting was adopted as the primary monitoring and influence solution and
was used as an efficient and effective means to control other agency costs and
to minimise opportunistic behaviour by corporate agents. The relative costs
and benefits favoured a ``light touch'' in terms of governance influence by FMs
over good performing companies. For example, the level of corporate executive
pay was not normally a problem in such companies and only became an issue
when performance declined. The incremental costs of high pay or perks were
seen as small relative to the larger shareholder wealth gain acquired from an
effective top management team.
Such relationships began to break down as corporate performance declined,
as FM influence factors declined and as adverse events occurred. The costs of
not intervening increased and included major increases expected in monitoring
and agency costs, large potential losses of shareholder wealth and other
potential costs such as reductions in shareholder rights. These exceeded the
costs of direct action, including the costs of legal action, forming coalitions and
perhaps loss of knowledge advantage. These costs were also associated with
changes in benefits of direct action such as the potentially beneficial impact on Financial
other portfolio companies, and of being able to match a new management team institutions
with an appropriate set of corporate assets. When these events occurred and
the above cost-benefit equation changed in this way, then the emerging conflict
between company and financial institution moved more to the public domain.
The focus moved from influencing corporate human capital through a positive
dialogue, to seeking forcefully to change management minds, to eventually 525
changing top management human capital. This intervention became the means
to make radical changes in other intangibles such as brand management skills
or new product development skills. Thus the implicit contracting model was
less relevant and the principal agency model became more descriptively
accurate under these circumstances. However, even here, changes in corporate
human capital were seen as the primary means to govern the other intangibles
in the corporate value-creation process.
The above suggests that future theoretical modelling and empirical research
on FM corporate governance should consider how the wide range of qualitative
corporate value-creation factors can be governed in the interests of
shareholders and other stakeholders. Such research should also widen the
theoretical framework to include a wider set of contracting options ranging
from implicit contracting to principal-agent theory. A narrow focus on
Cadbury- and Greenbury-style corporate governance mechanisms and on
principal-agency theory may lose sight of the role of such varied governance
and contracting mechanisms and their role in FMs encouraging corporate
enterprise and wealth creation.
The active nature of FM corporate governance also revealed how the case
financial institutions partially overcame Berle and Mean's (1967) problem of the
``separation of ownership and control''. The core financial institutions did this
through the regular and persistent probing of management, their skills, and of
other qualitative factors in corporate value creation. This control and influence
was exercised by individual institutions, but the collective efforts of 20 or so
core institutions meant that managerial discretion and degrees of freedom were
much curtailed compared to a situation where the shareholder base was
fragmented across many thousands of small investors.
This research also suggests that future theory building and empirical
research should consider both private and public domain corporate governance
mechanisms. Research methods such as questionnaire surveys of, say, voting
behaviour, or market-based methods investigating the price impact of such
public events, could be adapted to include hypotheses generated from the joint
public and private corporate governance role of financial institutions. Market-
based studies could use some of the early indicators of corporate decline to see
if the market reacted before a public dispute emerged. Thus early, private
signals of changes in company human capital and (management quality,
coherence of strategy), structural capital (effective board and reporting
mechanisms, quality of product or innovation processes, brand strengths,
AAAJ customer attitudes) could be used to identify market reactions and hence to
14,4 assess the `èarly bird'' role of the market as a corporate governor.
Some of these signals could emerge in various semi-private markets for
intangibles such as markets for technology and patents, brands and top
management, and these could be directly used in market reaction studies. Other
indirect public signals could arise through the intermediary role of FMs and
526 these include significant changes in FM ownership stakes, or in the overall
stability of the shareholder base. Other signals include changes in analyst
sentiment over time, of corporate management turnover, of changes in
technology licensing policy and policy on brand purchasing and sales. These
could all point to important internal corporate changes. However, many of
these early signals were more likely to emerge in the more private world of the
market for information between companies, analysts and institutions.
Identifying these signals, finding publicly observable proxies and measuring
their impact would reveal the relative significance and joint impact of these
private and public governance mechanisms.
It may also be possible to conduct studies covering changes over the period
1990 to 2001 when major changes in corporate governance mechanisms were
implemented. Thus the Cadbury, Greenbury, and Hampel reports have
strengthened FMs' ability to create strategic governance options such as
responsive boards and board committees. The changing circumstances
governance model, already outlined, would predict that as deterioration occurs
in the private and public performance factors, then these strategic options
would be exercised by FMs in private and in public. Thus the model would
predict increased turnover of management and boards towards the end of the
decade, assuming the same economic conditions and the same ``disturbing''
factors. Thus instead of modelling a simple relationship between FM
ownership and, say, company performance, the wider range of intermediary
(private and quasi public) relationships would also be explored. Such work has
begun with the research of Graves (1988), Allen (1993), Kochar and David
(1996), Bushee (1998), El-Gazzar (1998) and Johnson and Greening (1999), and it
now has to be extended to cover formally the joint world of private and public
corporate governance by FMs.
Conclusions
The present debate on corporate governance assumes that the financial
institutions have a corporate governance role but the debate and research have
(with the exception of Black and Coffee (1994), Holland (1995, 1998b) and
Stapledon (1996)) not clarified what this role is. The approach adopted in this
paper has generated new insights into private governance processes. In
particular it has extended our understanding of the nature of the private
qualitative agenda between companies and financial institutions, and has
identified the major qualitative factors perceived by the case FMs to be central
to the corporate value-creation process. These empirical results have also been
discussed within the debate on the nature of intellectual capital and intangibles.
This has provided the means to explore the private corporate governance Financial
process by FM in greater detail. The private dialogue and asking of probing institutions
questions on all of these intangible value-creation factors was an important
form of private FM governance concerning the corporate wealth-creation
agenda. A specific subset of these factors was also the major point for more
overt private FM corporate governance influence. The paper also identified the
key FM-side influence factors, and external events, that combined with adverse 527
changes in the intangible corporate value-creation factors, to stimulate a more
interventionist form of FM corporate governance. The paper has therefore
revealed how information on intangibles was a primary driver of private FM
governance and illustrated how financial institutions interacted with
companies on a dynamic, changing circumstances basis.
The clarification of the private FM influence process is valuable in many
contemporary debates. First of all, it provides a much clearer target for
corporate governance policy proposals, especially in terms of successors to

Cadbury, Greenbury and Hampel committees. Thus identifying which
qualitative factors FMs can use to influence companies directly or indirectly is
important for this debate. Identifying the differing circumstances under which
FM corporate governance occurs is also important for this debate. Second, the
role of institutions, in their own ethical investment decisions, and in influencing
companies on ethical matters and on social and environmental issues, are all
likely to be important issues in the twenty-first century. The explicit nature of
FM influence outlined in this paper can provide the means for analysts,
academics and others to explore how institutions can incorporate ethical,
environmental, and social issues within the existing FM influence process.
Third, the research also has the potential to guide national policy making
concerning the role of institutional shareholders in their portfolio companies.
Issues such as competitiveness and short-termism commonly focus on this
area.
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Accounting, Auditing & Accountability Journal

Financial institutions, intangibles and corporate governance

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Financial institutions, Financial

Introduction and outline of the paper

corporate governance role as corporate performance declined and other adverse

Brief survey of relevant related work

comparisons with the US system, and in the case of Stapledon, comparisons

between corporate social performance (the attributes of which included

This focus on public governance and controversial public events has

. nature of the private information agenda, including intellectual capital

Public corporate governance, public information sources and their

FM reasons for private corporate governance 505

Limitations of public information

announcement) private meetings took place. As a result, the contents of the

Acquiring information on intangibles directly from companies and

were expected to create changes in the immediate share price.

knowledge advantage concerning these qualitative factors and variables and

Private FM monitoring of intangibles, learning and impact influence

to govern indirectly many of the other qualitative factors determining

Corporate governance structures as internal structural capital

probing and implicit influence.

Differences between the qualitative factors in terms of information access and

The importance of managerial human capital as the pivotal influence point

Changes in intangibles and variation in the FM influence and

governance by FMs changed.

influence capability (C), and in corporate performance output factors (X).

Influencing the composition or actively changing the board and top

change other qualitative value creation factors such as coherence of strategy,

primarily a means of cooperation and mutual exchange of information and

corporate governance policy proposals, especially in terms of successors to

Journal of Finance, Vol. 51 No. 1, pp. 227-52.

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