Market participants appear broadly supportive of the U.K.'s proposed stewardship code for investors, yet questions over key aspects of its application remain.

In his November report on governance at U.K. financial institutions, Sir David Walker recommended that Britain's Financial Reporting Council (FRC) develop and encourage adherence to principles of best practice in stewardship by institutional investors and fund managers. The principles, Walker suggested, would draw from the Institutional Shareholders' Committee's (ISC) November Code on the Responsibilities of Institutional Investors and would apply on a "comply or explain" basis, akin to the market's Combined Code on Corporate Governance for issuers.

The FRC in January launched a consultation on the proposed stewardship code, seeking feedback on a number of questions, including: whether it should in fact be based on the ISC's code; what information investors should disclose regarding engagement policies and practices; and what arrangements should be put in place to monitor how the code is applied. The consultation period closed April 16.

Calling on investors to ensure good governance at investee companies has long been promoted by regulators and others, including asset owners themselves. But the debate was traditionally limited to the exercise of voting rights, which many viewed as the primary representation of active ownership. The global financial crisis sharpened focus on the need for investors to do more, and engagement between asset owners and corporate managers is seen by many as a critical component to those efforts.

The responses to the consultation underscore that approaches to engagement are not uniform.  Asset managers subject to short-term performance pressures will be less likely to engage than those with a long-term investment horizon.  As one respondent noted, short-term investors will be more likely to devote money and human capital to stock picking and equity trading than to engagement.  Such funds may choose to benefit as a "free rider" from the engagement of long-only investors, moreover. How, observers question, will the FRC address this?

Concerns over engagement costs--such as through increased administration or other fees--was common in many responses, with some questioning whether investors bearing such costs would be at a competitive disadvantage compared with rivals who choose not to engage.

One respondent suggested financial incentives as a means of mitigating these concerns. Incentives could include enhanced dividends or long-term tax benefits for good stewards. A means for raising funds to reward good stewards could be a market-based levy on listed companies or a transaction levy on shares traded, the respondent noted. The benefit of such an approach, the respondent argued, is that the fees would be spread across all investors.

Another question raised by many respondents concerned how to treat non-U.K. investors who collectively now hold upwards of 40 percent of the country's equity market. Would they voluntarily adhere to a stewardship code, and, if not, how relevant or effective would the code be?  And would adoption of the code result in a non-U.K. investor being subject to any FRC rules?

The need for foreign investors to buy in to a stewardship code is critical, observers say. "It's no longer possible for U.K. corporate governance to be a cozy matter managed by U.K. corporates and U.K. long-term investing institutions," National Association of Pension Funds chair Lindsay Tomlinson told attendees at a International Corporate Governance Network (ICGN) conference in March.  "For the U.K.'s comply-or-explain regime to work, it's going to be necessary for international investors to engage themselves in the affairs of U.K. companies."

The California State Teachers' Retirement System said late last year it would adopt the code, though other non-U.K. asset managers have largely remained silent.

Another area of uncertainty centers on the practice of stock lending by institutions, which the code does not address. Many respondents suggest that asset managers should disclose policies related to lending, and the recalling of loaned shares for purposes of voting, as a practice of good stewardship.

In its consultation response, the U.K.'s Institute of Directors proposed that the code include the following principles to address concerns over lending:

• It is bad practice to borrow shares for the purpose of shareholder voting;
• Institutional shareholders should have a clear and disclosed policy with respect to the lending of shareholdings;
• Lending policy should be mandated by the ultimate beneficial owners of the shares;
• Where lending activity may alter the risk characteristics of a portfolio, the investor's investment policy should state the extent to which this is permitted; and
• The returns from lending should be disclosed separately from other investment returns when reporting to clients or beneficiaries.

Other respondents suggest that the code call for institutions to adopt the ICGN's principles on lending.

The FRC will mull the dozens of responses over the coming months, and likely will publish a final code before September. Given the U.K. market's role as a governance paragon, consensus on code principles will be critical to practices of good stewardship taking root globally.