Colin Melvin, the chief executive officer of Hermes Equity Ownership Services, is on a mission to empower investors to enforce their rights, especially in light of what the global credit crisis has wrought. In an op-ed piece in the London Daily Mail earlier this year, Melvin argued to end the short dance and begin a real conversation with the large companies that as pensioners, and now taxpayers, “we collectively own.” Hermes works alongside some of the world’s largest pension funds to help them understand and engage with the companies they invest in on issues such as transparency, accountability, governance, and longterm strategy. Directorship spoke with Melvin just after news of the Satyam corporate fraud in India began making headlines and other fraud cases, such as the Bernard Madoff scheme, were coming to light.

Pension fund trustees certainly have little to cheer about. What can they do now?
We currently advise 11 large funds that own shares in many companies around the world, including many financial-services firms. We’re engaging with these banks on their risk management, strategies, and the ways in which they pay themselves. If these questions had been asked earlier by more people, we would not be where we are today. We often behave as though banks were operating independently, as if they didn’t have owners. It is in pension funds’ longterm interests to have a dialogue with the companies they invest in. This process of engagement involves direct board-level contact and is most effective when it is collaborative. We do have robust conversations, but most companies appreciate and benefit from a dialogue with their long-term shareholders. This seems rather obvious, but companies that are well managed and do the right thing tend to do better in the long run.

How do we end this downward spiral?
Part of it is lack of confidence and trust, and the problem that no one (including the banks) seems to know how much the banks are worth. Globally, there’s a real opportunity for big pension funds and insurance companies and the banks they invest in to work together. There is also an opportunity for more collaborative and longer-term thinking. Everyone’s retrenched and lending on a very short-term basis, but it’s in their rational self interest to begin working with one another.

But somebody’s got to go first?
Absolutely. The large funds should get together and demonstrate some leadership themselves and start the dialogue. Part of the reason I’m here [in the United States] is to talk to prospective pension-fund clients. We offer a service through Hermes EOS to empower pension funds and enable them to work together to be better owners of companies.

Are you optimistic about corporate governance changes as a result of this environment?
It’s essential and long overdue. The United States has possibly the worst governance environment. Shareholders’ rights are stronger in the U.K. and pretty much every other country. The United States is lagging and that has contributed to the current problems. Shareholders lack key rights and the large pension-fund owners of U.S. companies could do a better, more responsible job with majority directors elections, access to the proxy, and say on pay. Our experience in the U.K. is that such rights improve the quality of the dialogue between companies and their shareholders to mutual benefit. Funds will also need some encouragement to exercise their rights. I expect this will happen with the [Obama] administration.

Do you think CEO compensation problems are restricted to a few widely publicized, egregious cases, or are the excesses widespread?
This is a consequence of lack of oversight, a lack of shareholder rights, and a lack of transparency. CEO pay must be aligned with the interest of shareholders and customers. Are there models? The only model for Hermes EOS is what is in our clients’ best interests—better managed, more valuable companies to invest in. We are not pushing any particular compensation model. The right model is that which encourages long-term, sustainable financial and business success.

Should there be a cap on executive pay?
I would hope that wouldn’t be necessary if the large, long-term shareholders were acting in their own rational self-interest. This should occur naturally. We don’t want government and regulators to intervene, so we should get our own houses in order and create a more efficient market that reflects the interests of participants. We should also look to local best practices. We were talking to several banks over the past two years and challenged them about the ways they were paying traders. They claimed that there was a market for executive talent that required a certain level of pay. We strongly encouraged banks to work together to produce a best-practice model for their industry and their market.

In your view, has U.S.-style litigation had any effect outside of the United States?
I don’t think it’s spreading. Such litigation seems unique to the United States because of corporate law and the relatively poor level of shareholder rights. Although we should expect shareholders to take action when they have been defrauded, many securities class actions are opportunistic and distracting to corporate management. Also, as a long-term shareholder, it is rather like suing yourself. You take money out of one pocket, give some to the lawyers, and put the remainder back in another pocket.

Is there a particular shareholder bill of rights to which you subscribe?
We support local best practice. There’s no one ideal set of rights, although the best governance systems facilitate good corporate management and accountability to the owner. The problem with “corporate governance” as it is too often interpreted and practiced is that it has become an exercise in compliance, rather than good corporate management and ownership. Companies need responsible and interested owners, rather than box-ticking traders of their shares.

How have corporate frauds, such as the one the former CEO of Satyam admitted to, affected how Hermes looks at governance in countries such as India?
India is a really interesting example because quarterly reporting has brought such a short-term focus and pressure to companies, perhaps even more so than in the United States. Small adjustments, or a small lie, become magnified over time as the adjustments continue. Weak corporate management may try to maintain growth in earnings to meet the expectations of asset managers with a short-term focus. This is very different than the challenge we provide to companies through Hermes EOS. The conversation that CEOs and CFOs frequently have with the City of London or on Wall Street is very short term and generally not about the substance of the businesses they are running.

Short selling has also been blamed for creating a short-term focus. Has it become a big problem?
Short selling is not in itself bad, but it needs to be properly controlled and there should be more transparency. Also, those people who are facilitating short selling by lending their stock should do so in a managed way, monitoring the lending volumes and corporate actions. This sort of rational, self-interested control by pension funds and other long-term end owners of companies is esssential if we are to avoid heavy-handed regulation in this area. The best regulation will provide additional transparency and create open and transparent markets, which are necessary for restoring trust in our financial system. It is then for the market participants to behave responsibly and at the very least, avoid doing damage to the financial system on which we all depend.

Should we do away with quarterly reporting?
I don’t see the benefit of it. What’s more important is that the end investors should take control of the situation and demand better terms from management for their money. As we look ahead, I hope that pension funds and other institutions will rise to the challenges presented by the credit crisis and help build a more stable and sustainable platform for growth.

Placing part of a bonus risk and attaching strings may solve some incentive pay problems.

Before the advent of stock-option expensing several years ago, traditional stock options didn’t have much competition when it came to rewarding top executives.

A Customized, In-Boardroom Approach

Corporate governance practices in the U.K. take a “comply or explain” approach.