Ethical finance

Context

Ethical and sustainability screening - Bank The Co-operative Bank launched its Ethical Policy in 1992, and this was subsequently reviewed in 1995, 1998 and 2001. Follow this link for the current Ethical Policy. In each instance, the Ethical Policy has been formulated on the basis of an extensive programme of customer consultation. The current Ethical Policy followed consultation with almost one million corporate and personal customers. The Ethical Policy stipulates who the bank will and will not finance, as directed by customers. It covers all of the bank's assets (e.g., retail and syndicated loans, and corporate leasing) and liabilities (e.g., retail deposits and savings, and treasury dealings), and the investment of all retained balances. The bank's Ethical Policy is currently all but unique in UK retail banking, in so far as it contains explicit clauses that restrict the provision of financial services to certain activities and sectors. The bank has previously provided a detailed annual breakdown of all instances were business has been declined.i For the first time this year, an ethical and sustainability analysis is provided of the bank's corporate and business banking lending and deposits balance sheet. Details of the bank's ethical and sustainability analysis are reported here.

Responsible shareholding - CIS CIS' Responsible Shareholding approach was launched in 1999. It is based on engagement with the companies in which shares are held, with the aim of realising improvements in financial, ethical and sustainability performance. To date, the focus of corporate engagement has been predominantly on issues of governance and executive remuneration, but it has also embraced the ethical and sustainability performance of companies. CIS was the first UK investor to put its entire UK voting record on its website (November 2002) and is committed to exercising its voting rights at every available opportunity in every company in which it invests. This Report provides, for the first time, a detailed analysis of CIS' voting and engagement activity.

Assurance - CFS The bank's Ethical Policy implementation and CIS' Responsible Shareholding activity are, like the rest of this Report, subject to rigorous third-party verification. Whilst many financial services organisations across the world now produce social and environmental reports, few, if any, subject the provision of finance to external assurance.

Anti-money laundering - CFS Money laundering is the disguising of funds derived from criminal activity to give them legal respectability. It has been estimated by the International Monetary Fund ii that such financial flows are equivalent to between 2% and 5% of global Gross Domestic Product. As set out in the Financial Services and Markets Act 2000, the Financial Services Authority (FSA) has formal powers in the UK to supervise and, where necessary, enforce corporate and individual compliance with laws and regulations in connection with financial crime, including money laundering. The FSA's rules, as set out in the Money Laundering Handbook,iii came into force on 1 December 2001.These are rules are complemented by more detailed industry guidance produced by an industry body, the Joint Money Laundering Steering Group (JMLSG).iv

Commentary

Policy development In 2003, a project was developed to substantially reconcile the historically different approaches of CIS and The Co-operative Bank to Socially Responsible Investment. Reconciliation will focus on establishing a clear customer mandate for CIS' Responsible Shareholding policies, much as bank customers currently guide its ethical investment. It is planned that, following extensive customer consultation during 2004, a new CIS Socially Responsible Investment (SRI) Policy will be launched in early 2005. This new policy will cover all asset classes - shares, bonds and property. Unlike the bank, restrictive ethical investment is unlikely to be the focus of the new CIS SRI Policy; instead there will be a clear commitment from CIS to use its influence for the benefit of customers and society alike. Depending on CIS customer feedback, it is feasible a situation could evolve whereby in 2005 the bank could continue to decline to finance a particular business as a consequence of it exporting arms to oppressive regimes, whilst CIS would leverage its shareholdings in the same business to question whether such activity is conducive to robust long-term financial performance. The process to engage CIS' five million customers in the development of an SRI Policy began in March 2004. A customer registration campaign was initiated to ensure that all customers who wish to have their say and vote (scheduled for summer 2004) are given every opportunity. For example, 'the SRI vote' is the lead banner on the CIS websitev and advertisements and news articles have been secured in the spring edition of the customer magazine Real. The project has received extensive national press coverage and advertisements have been placed in the UK specialist ethical and sustainability press. Staff have been advised of developments through the CFS intranet and staff magazine, whilst CIS' Service Centre staff have been advised through dedicated team briefings. It is anticipated that CIS' Financial Advisers will act as a unique and key channel for engaging with customers and securing participation.

Ethical and sustainability screening - Bank During 2003, the bank's Ethical Policy Unit reviewed 225 potentially problematic financial opportunities (a 57% increase on 2002). Each was referred by a Business Development Manager who wanted to ensure that their business opportunity was compliant with the bank's Ethical Policy. Of these, 20% were found to be in conflict with the Ethical Policy and the business opportunity was declined. Details of all business declined in 2003 are provided here, together with an estimate of gross income foregone (annualised basis). The degree to which the bank finances organisations that make a particularly positive contribution to society (i.e. above and beyond Ethical Policy compliance) is described here. Details of how the bank used the Ethical Policy to screen suppliers in 2003 are described separately here. For legal reasons, the bank is unable to name those businesses found to be in conflict with its Policy; this would constitute a breach of customer confidentiality. However, all referrals to the bank's Ethical Policy Unit are subject to independent third-party scrutiny. CFS' Sustainability Auditors, justassurance, directly investigate the veracity of the Ethical Policy implementation programme, reviewing, on a sample basis, the Ethical Policy Unit's case files. They also liaise with the bank's internal audit function to pursue a broader level of assurance on the quality of the referral process in operation across the business. This internal Quality Assurance Programme involves the review of case files in the Corporate Banking Network, Treasury, Transmissions, the New Business Centre, Advances and Asset Finance. In total, internal audit devoted 19 days to such assurance in 2003. In 2004, it is anticipated that there will be a further increase in the volume of ethical screening, as a result of the bank's more frequent participation in syndicated loan activity. The merger of CIS' and the bank's ethical and sustainability functions within the new CFS Sustainable Development Team has provided the opportunity for increased resource and a review of ethical screening processes.
 Research undertaken by EIRIS (2003)vi rated The Co-operative Bank's Environmental Policy as the best of 13 UK retail banks, and stated it was "exceptional." Additionally, it noted that The Co-operative Bank was the only one to have "explicit policies" in relation to "lending to companies/organisations with a significant involvement in arms, or countries considered to be under the rule of oppressive regimes, and/or organisations with a poor environmental record."
German rating agency, Oekom,vii published a review of Europe's 13 most ethical banks in 2000, many of which were 'small' in size. The Co-operative Bank rated fourth, with a Corporate Responsibility Rating of A-. Subsequently, in 2002 Oekom undertook a review of 93 of the world's largest banks and financial service providers (this did not include The Co-operative Bank), HypoVereinsbank of Germany led with a B rating. At the time the Bank was awarded its A- rating, this was the highest score achieved by a UK company in any sector.

Responsible shareholding - CIS During 2003, the vast bulk of CIS engagement activity was focused on matters of corporate governance. Ethical and sustainability engagement was less in volume, but remains a particular source of interest to CFS' partners, and each instance is referenced here. All CIS engagement activity is subject to independent third-party scrutiny, with particular attention given to matters of ethics and sustainability. CFS' sustainability auditors, justassurance, directly investigate, on a sample basis, the veracity of responsible shareholding activity, reviewing case files relating to ethics and sustainability and assuring themselves of the integrity of the process and outcome. For reporting purposes, 'engagement' is taken to cover instances where CIS has pressed a point of difference with a company or where CIS has proactively endorsed a material ethical or sustainability initiative. Letters of enquiry and seminar attendance are not classified as 'engagement'. Research is necessary if successful engagement is to prosper, but much research never translates into the pursuit of an ethical and sustainability point of difference with a company, and therefore CFS believes that the two should be differentiated. The term 'engagement' is not taken to cover endorsements of corporate behaviour that are essentially the sector norm, or close to it. Engagement can be pursued via correspondence, face-to-face meetings, or most significantly via attendance and the exercise of voting rights at a company's annual general meeting. Currently, ethics and sustainability research and analysis is not routinely factored into CIS investment decision-making. However, such considerations are now under active investigation.

UK corporate governance engagement  activity - CIS At the outset of 2003, 86% of CIS' equity holdings were listed on the UK stock exchange. With regard to UK shareholdings, it is CIS' policy to vote on every resolution put before it and to make all decisions available on its website.viii In 2002, CIS developed a UK Corporate Governance and UK Voting Policy. This was trialed through 2003 and was formally approved early in 2004. This states that CIS will vote 'against' a resolution where it "is inconsistent with its guidelines,ix does not accord with best practice, and is not in shareholders' long-term interests". However, in the first instance, and where the issue is not considered fundamental, CIS will tend to abstain on such issues, and only vote against a company when responsiveness has failed to emerge from previous engagements. CIS will also abstain on resolutions where performance falls short of best pratice, but it is not sufficiently material. Where CIS plans not to support a company's board, the affected company is informed in writing in advance of concerns. In 2003, CIS voted on 7,405 UK resolutions tabled by management, as detailed below. It voted against, or abstained on, 10.4%. CIS attended 57 AGMs during 2003 (representing 19% of UK holdings, end 2003), and made statements or raised questions at 38 of these.

• The major issues of concern were executive remuneration and the election of Directors, and these accounted for 77% (592) of all votes against/abstentions. One reason for this was a new legal requirement in the UK for companies to put the approval of their remuneration reports to the vote, and CIS took part in several shareholder efforts to limit excessive pay.
• More positively, during 2003, there was an increase in the frequency with which CIS voted in favour of the election of UK directors (85%) due to the prevalence of more 'independents' amongst non-executive directors.
• In connection with the receipt of UK company Reports and Accounts, votes against and abstentions rose to 64 in 2003, and were in large part (37) driven by CIS' increased willingness to apply pressure to those who fail to disclose environmental policy and/or material social, ethical and environmental (SEE) risks (see below).

The threat of legislation, updated stock exchange listing rules and the activism undertaken by a range of Institutional Investors would, in combination, seem to be making a positive impact on UK corporate governance. A reviewx of the FTSE All Share Index in 2003 found that over the four years of operation of the Combined Code on Corporate Governance there had been "significant improvements in compliance", but that "in certain key areas there remain significant numbers of companies which choose not to comply".

Research undertaken by the Investment Management Associationxi found that the vast majority of institutional fund managers (94%) had a policy to vote all their UK shares and, where possible, international shares.
Research undertaken by PIRCxii found that, in respect of FTSE All Share index companies, fewer than 4% of votes were cast either against or as abstentions during 2003, with these options being used in approximately equal measure.
Currently (as at April 2004), just two UK institutional investors, including CIS, disclose their entire UK voting records.

Overseas corporate governance engagement activity - CIS At the outset of 2003, 14% of CIS equity holdings are listed outside of the UK, principally in the United States, continental Europe and Japan. CIS does not retain central records of all overseas voting activity. However, records are maintained for all overseas voting activity that culminates in 'opposition' to management, as described below. During 2003, CIS voted against, or abstained on, 298 overseas resolutions tabled by management, none of which had ethical or sustainability components. In addition, the culture of shareholder activism is particularly advanced in the United States; independent groups frequently secure the required number of shares to enable a resolution to be tabled which might normally be opposed by management. In 2003, CIS acted in support of 135 independent resolutions. In 15 cases resolutions had ethical or sustainability components, as described below. It is recognised that CFS' Partners would have an interest in understanding how CIS votes in respect of all independent resolutions, and this will be reported on in 2005.

Ethics and sustainability engagement activity - CIS During 2003, CIS carried out research into aspects of the ethical and sustainability performance of 44 companies. Subsequently, as described below, engagement programmes were initiated (or an existing engagement programme was extended) with 14. Engagement consisted of face-to-face meetings or correspondence. The aforementioned statistics include instances of collaborative engagement that directly involve CIS (i.e. when present at a meeting). Most significantly, CIS chairs the Pharmaceutical Shareowners Group and actively participates in the Extractive Industries Transparency Initiative and the Institutional Investor Group on Burma. Follow this link for details of CIS' Burma engagement. CFS involvement in the Carbon Disclosure Project is described here. In addition, during 2003, in 37 instances CIS voted against, or abstained on, the acceptance of UK company report and accounts due to their failure to disclose an environmental policy and/or material SEE risks. Overseas, CIS supported 15 independent shareholder resolutions with ethical or sustainability components. These proposed that nine US companies improve various aspects of their social, ethical and environmental policies, reporting and risk management as described below.

Anti-money laundering and financial crime prevention - CFS The scope of CFS' obligations and activities in these areas has continued to expand in 2003. Traditionally, in line with the rest of the financial services industry, work has focused on anti-money laundering measures. With the introduction of new legislation, including the Proceeds of Crime Act 2002 (which came into force in February 2003), CIS and the bank are now required to identify and disclose to law enforcement agencies suspicious activity that may be indicative of a broader range of financial crime, including activities such as benefit fraud and tax evasion. This requires regular appraisal of investment levels in areas such as new account opening, activity monitoring, and may involve increased resources and new training processes. Such measures are critical at a time when the industry is continuing to witness steep growth in the movement of funds connected with financial crime.

Sustainability value analysis

• Estimated annualised gross income foregone in 2003 for ethical reasons - £6,887,000. It should be noted that this figure relates to that portion of business declined where a referral was made to the Ethical Policy Unit and income would have been anticipated during 2003. This takes account of referrals made in years prior to 2003, but where income would have been anticipated during 2003. There are many other business opportunities foregone, where staff decline business, without referral, knowing the business would be in breach of the bank's Ethical Policy.

Influence and action

Annual General Meetings (AGMs) Company AGMs provide shareholders with an excellent means to make directors publicly accountable. However, this opportunity is currently under-utilised by institutional investors. To help bring the spotlight back on to the AGM as a valid and important engagement tool, in 2003 CIS launched an 'AGM of the Year' Award, which was won by Renishaw.

i   www.co-operativebank.co.uk/ethics/partnership2002/pr/screening_finance.html
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ii  Financial Times (18.11.02), Money laundering: Ironing out those washday wrinkles.
iii  www.fsa.gov.uk/vhb/html/ml/MLtoc.html
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iv  www.jmlsg.org.uk
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v  www.cis.co.uk
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vi  EIRIS Guide to Responsible Banking (November 2003).
vii  www.oekom.de
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viii  www.cis.co.uk
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ix  www.cfs.co.uk/sustainability2003/CISguidelines
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x  Corporate Governance Annual Review 2003. Pensions & Investment Research Consultants Ltd (November 2003). Sample comprised 508 companies.
xi  Survey of Fund Managers Engagement with Companies (March 2004). Investment Management Association. Based on a survey of 33 firms (representing over half of the value of UK equities managed within the UK). www.investmentuk.org/press/2004/20040325.htm
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xii  Corporate Governance Annual Review 2003. Pensions & Investment Research Consultants Ltd (November 2003). Sample comprised 508 companies.