Stewardship code

An institution that owns shares in a listed company can do one of two things when the company governs itself badly. It can sell, or it can act like an owner.

The Stewardship Code makes the second one an obligation rather than a choice. SEBI mandated it for all mutual funds and all categories of AIFs in relation to their investments in listed equities, by circular dated 24 December 2019. The premise is that an institutional investor is deploying somebody else's money, and passive shareholding is not a neutral act — it is a decision to let the investee company's management do as it likes with the clients' capital.

So the code requires policies, and requires them to be public: how the AIF discharges stewardship, how it handles its own conflicts, how it monitors, when it intervenes, and how it votes.

The code is stated as a set of principles, each of which is a policy requirement rather than a behaviour requirement — the AIF must have a written, disclosed policy, and it must follow it:

1. Formulate and publicly disclose a stewardship policy, reviewed and updated periodically, with the updated version on the entity's website.
2. Have a clear, publicly disclosed conflicts policy for stewardship, which must place the client's or beneficiary's interest before the entity's own, and must address what happens when two clients' interests diverge from each other.
3. Monitor investee companies continuously, under a policy stating the areas and extent of monitoring — including where monitoring is not required — and keeping the insider trading regulations in mind when seeking information.
4. Have a clear intervention policy, and a policy on collaborating with other institutional investors, identifying the circumstances for active intervention and its manner: discussions with management, meetings with the board, collaboration with other investors, voting against decisions.
5. Have a clear voting policy and disclose voting activity — taking independent voting decisions after in-depth analysis rather than blindly supporting management, with the mechanisms, the circumstances for voting for, against or abstaining, and the disclosure of votes.
6. Report periodically on stewardship activities to clients and beneficiaries, in an easy-to-understand format, which may also be placed on the website.

Stewardship responsibilities themselves cover monitoring and actively engaging on financial and operational performance, strategy, corporate governance including board structure and remuneration, capital structure, and material environmental, social and governance opportunities and risks.

Where it shows up in the fund's own paperwork: annual statutory reporting by AIFs includes a section on the discharge of stewardship responsibilities by the manager, and Chapter 7 treats the code as part of the ESG risk that the manager must build internal controls, processes and systems to manage.

A discrepancy to know before the exam. Chapter 7, section 7.1.8 states the code is based on five principles and lists 1 to 5. Chapter 15, section 15.2.1 lists six, adding Principle 6 on periodic reporting of stewardship activities. Both are in this workbook, in the same edition. Neither list contradicts the other on the content of principles 1 to 5.

Meridian Long-Short Fund, a Category III AIF with Rs 450 crore of assets, holds Rs 36 crore of a listed mid-cap auto components maker — 8% of the fund, and about 2.4% of the company.

The company calls a shareholder meeting to approve a Rs 180 crore related-party purchase of land from the promoter family. Independent valuers put the land at about Rs 120 crore.

Walk the principles:

The fund votes against. It holds 2.4% and loses. The code is still satisfied, because the code governs the process, not the outcome — Meridian had a disclosed policy, applied it, voted on its own analysis and told its investors.

Had the fund abstained with no policy and no record, it would have failed the code on a resolution that cost the company Rs 60 crore of value, of which the fund's own share was about Rs 1.44 crore — more than a third of a year's management fee at 1% on Rs 450 crore.

Chapter 7 (Alternative Investment Funds Ecosystem), section 7.1.8 introduces the Stewardship Code under ESG, and Chapter 15 (Fund Monitoring, Reporting and Exit), section 15.2.1 sets out the principles in full as part of the transparency and disclosure requirements. Chapter 11 treats stewardship as part of fund governance. Expect recall questions on which entities the code binds (all mutual funds and all categories of AIFs, for listed equity investments), on the count and content of the principles, and on the date of the December 2019 circular.

• The workbook gives two different counts. Chapter 7 says the code is based on five principles; Chapter 15 lists six, the sixth being periodic reporting on stewardship activities. If a question asks for a number, take it from the chapter it is drawn from.
• The code applies to listed equity investments. An AIF whose portfolio is entirely unlisted still needs the policies, but the stewardship obligations bite on the listed book.
• It binds all categories of AIF, not only Category III. The same circular covers all mutual funds.
• Each principle requires a written, publicly disclosed policy. Doing the right thing without a disclosed policy does not discharge the code.
• Principle 3 is bounded by insider trading law. Monitoring does not license an AIF to extract unpublished price-sensitive information from an investee company.
• Stewardship is not the same as the conflict-of-interest obligations under Regulation 20, though they overlap: the stewardship conflicts policy is specifically about conflicts arising in the discharge of stewardship.