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Governance and ResponsibleInvestment Quarterly Report

Policy documentApril to June 2012 Governance and Responsible InvestmentInformation for Investment Professionals

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SummaryThe second quarter is always busy as the annual general meeting (AGM) season peaks,which this year saw Threadneedle voting at 1053 meetings across 43 markets. Not leastthis season has seen a number of high profile cases of shareholder dissent andsubsequent management change. The quarter provides a milestone in our on-goingengagement activities, with our voting helping to underline our views and messages onthe issues under discussion and more generally. Around that, we have focussed ourengagement on 53 companies across a range of ESG issues.

Over the quarter, we have also attended a number of ESG related events to ensure westay attuned to industry thinking and developments. These events included meetings withUNPRI, UKSIF, SIF Japan, EUROSIF, the London Stock Exchange, BIS, CompetitionCommission and the ACCA, as well as attending the annual CERES conference on thetheme “Igniting Innovation, Scaling Sustainability”. The conference discussed broadnatural resource themes in the US context, focusing on long-term economic developmentand the need to stimulate market forces by adequately pricing natural resources.Persistent themes throughout the conference were green growth, job creation and issuesaround energy security.

June saw Rio+20, the United Nations Conference on Sustainable Development. While thefinal text is considered ‘weak’ by some NGOs, it was largely what was anticipated.Interestingly, corporates came to the fore at the summit, with the private sectoreffectively taking a lead in the sustainability arena.

Proxy Voting As noted, during the quarter, we voted at 1053 meetings across 43 markets. For manymarkets, the second quarter is the main proxy voting season, with particularly highvolumes of meetings in the UK, Japan, Hong Kong and United States.

In terms of activity, we voted against one or more management recommendations at 427(41%) of these meetings across a range of issues. Where we took voting action againstmanagement’s recommendations, we voted against 72% of resolutions and abstained on27% (see graphs below).

Primarily this quarter, we have voted against director elections or re-elections where webelieve there are concerns relating to the board composition, or the performance ofdirectors. Remuneration has remained a contentious issue, particularly in the UK, where46% of Threadneedle’s votes against management related to remuneration practices andpay for performance.

Capitalisation authorities also make up a significant portion of Threadneedle’s votesagainst management. The variations between share issuance practices across marketsrequire shareholders to closely monitor the potential dilutive nature of such authoritieswhile considering the specific company strategic requirements.

Engagement effortsThis quarter, we have engaged with 53 companies on a range of ESG issues. Given thehigh volume of proxy voting this quarter, Threadneedle met with and entered intodiscussions with a number of holdings where we perceived there to be particularlycontentious voting issues that warranted increased engagement.

The so called ‘shareholder spring’ has seen a marked increase in voting action in the UKwhere there have been concerns about the alignment of pay arrangements withshareholders. While we have yet to see whether this trend will endure (in the past suchtrends have faded in the face of economic and market recovery) the situation is notable asfurther reforms are progressed to introduce a binding vote on executive pay in the UK.However, the trend and voting down of a notable number of remuneration reports isnevertheless significant, not least given the onus placed on investor engagement by theUK’s Stewardship Code as well as an increased interest and expectation amongstinstitutional and retail fund managers’ clients.

Financial organisations have been under particular scrutiny in terms of their performance,incentive structure and the quantum of awards paid to senior management, which manyshareholders perceive to be misaligned with shareholder returns. During the past fewmonths, we have engaged with, for example, Aviva, Credit Suisse and Barclays about theseissues. At each of the companies’ annual general meetings, shareholders successfullyvoted down the remuneration report. Given the broader issues Aviva and Barclays havesince seen significant leadership changes, which we discuss in more detail below.

Proxy Voting by Geography April to June 2012

32%

15% 17%

20%

15%

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35%

UK Europe North America

Far East and Emerging Markets

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Resolutions Voted Against Management

38%

25%

19%

9%

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35%

40%

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BarclaysAs the quarter came to a close, Barclays’s admission that it falsified its Libor (the LondonInterbank Offered Rate) submissions and would pay £290 million in settlements, becamethe lightning rod that finally crystallised a backlash around the long-standing concernssurrounding the bank’s culture and practices. Those issues have been the focus of ourengagement with Barclays. This follows on from the related issues around the lack ofshareholder alignment seen in their executive remuneration (26.9% of the shares werevoted against the bank’s remuneration report, with more abstaining), which haveconcerned Threadneedle and others.

Although the Libor scandal has been the particular context in which the various departuresfrom Barclays have played out, the seeds of recent events were sowed sometime back.This was illustrated in a comment piece in `The Financial Times’ (9 July 2012) by a formerBarclays chief executive, Martin Taylor, who admitted that he had mistakenly succumbedto the myth of Diamond’s indispensability in 1998 and had not removed him. The issuethen involved one of Bob Diamond’s units circumventing their trading limits afterDiamond’s request to increase them fivefold had been rejected, leaving Barclays nursinghundreds of millions of pounds in losses from the Russian debt default.

Even leaving aside issues such as controversial capital raising in 2008, the aggressiveapproach to capital and management of the balance sheet (e.g. the Protium scheme in2009) and the lack of shareholder alignment in its executive pay arrangements, the lastcouple of years have seen a litany of issues come back to haunt Barclays . These ,including: its aggressive tax avoidance practices and schemes; the payment-protectioninsurance (PPI) mis-selling; the mis-selling of SWAPs to SMEs; the mis-selling ofinvestment funds; the mis-selling of GSE Certificates (a form of mortgage-backedsecurity); the mis-selling of other sub-prime securities; the alleged mis-selling of asynthetic CDO known as Corvus; the altering of financial records to hide financialtransactions originating in Cuba, Libya, Iran, and other sanctioned countries; significantconflicts of interest and alleged mis-use of confidential client information; mishandling ofclient money; various failures in Barclays’ internal controls; failures to provide accuratereports to the regulator; and inadequate management of its electronic data-processingsystems. This record and not only the Libor scandal, explains the extreme events ofrecent weeks.

Clearly there are lessons that have to be learnt and it will be important that the Chairmanand other non-executive directors are allowed to address the issues and keep the bankmoving forward sensibly and prudently. At the same time, it remains essential that allinterested parties are focused on what is ultimately important. That is having a credible,stable and sustainable banking system. In that context it will be important that regulators,politicians and policymakers ensure they have a clear and joined up approach that enablesthe banks to de-risk their balance sheets sensibly and develop a viable economic model,within a framework that allows them to attract external capital.”

AvivaAviva was the subject of notable and widespread shareholder revolt at its AGM. Theheadline issue was the company’s remuneration report, driven off pay-rises, bonuspayments, a poorly structured recruitment package and performance. Threadneedle andother shareholders voted down the report (54% of the shares were voted against theremuneration report, with more abstaining).

Behind this though was a deeper concern. The company had endured a significant periodof underperformance, both in terms of share price and operational performance, and had apressing need to strengthen its capital base and reconsider its strategy. Those issues andthe board’s view of them, as well as intensifying shareholder pressure, led to theresignation of the CEO, Andrew Moss, a week after the AGM. John McFarlane, theChairman designate became Executive Deputy Chairman with immediate effect beforetaking over as Executive Chairman at the end of the quarter, pending the appointment of anew CEO. In the interim the new priorities for Aviva are four-fold: focusing on (i) a review

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of all businesses, (ii) building financial strength, (iii) launching a profit improvementprogram and (iv) improving customer service.

Our engagement with the company in the run up to the AGM and post it has now shiftedto monitoring progress on succession and the delivery of the new priorities, as well asassisting the Remuneration Committee chairman in shaping a detailed review of theremuneration arrangements.

AntofagastaThe team met with Antofagasta to discuss a range of ESG issues. This included theintegration of their environmental and social issues in operations, such as the innovativeuse of sea water in resource-constrained locations, health and safety management, andstrategic opportunities outside of Chile. It also allowed us to discuss the company’s recentmanagement changes and succession plans following the departure of the CEO. Thisfocused on our concerns about the board composition, in particular the independentrepresentation on the board and diversity of experience, principally internationalexperience, given the poor venture into Pakistan.

We followed up this engagement by voting against the controlling shareholder Jean-PaulLuksic as the board failed to give guidance on the replacement of the CEO, leaving us withon-going concerns about the concentration of power. We also opposed director GuillermoLuksic due to our concerns about the balance of the board and his continually poor boardattendance.

Deutsche TelekomThe team met with the Head of Corporate Sustainability and the Head of CorporateResponsibility to discuss labour relations and joint ventures given recent controversies.

The discussions centred predominantly on on-going allegations that Deutsche Telekom’sUS operation T-Mobile is anti-union. This is not a new issue and the group appear to be instalemate with unions despite trying to broker a global workforce agreement and tointroduce an intermediary. There are cost implications - the company anticipates that fullyunionised salaries would increase by several percentage points. However this must beconsidered in the context of the risk of industrial action, labour turnover and productivityimpacts.

In Germany, Deutsche Telekom has just agreed a deal with unions to increase wages by6.5% over two years. The company accepts this will be economically difficult givenexpected revenue contraction. Deutsche Telekom also notes difficulties in improvingoperational efficiency in certain markets, such as Greece and Croatia, due to labour normsand austerity measures.

We also covered corruption and bribery in the wake of the Magyar controversy - thecompany believes it is now managing these risks better. We perceive that the greatestthreat comes from joint ventures and exposure to corruption from partners who may havesecured licences. In that context effective risk management is critical. Due diligence andanti-competitive behaviour related to joint ventures are issues we have therefore identifiedfor further investigation and engagement.

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Integrated ESG researchThis quarter we have contributed to the equity desks’ global sector reviews on globalhealthcare and global energy.

These are both sectors, which we have covered from an ESG research perspective for along time. We regularly meet companies in global pharma, such as GSK, AstraZeneca,Novartis, Novo Nordisk. Likewise, in global energy we have a regular dialogue withcompanies such as BP, Shell, Exxon, and Chevron. In addition to dialogue andconversation with companies, we meet brokers and experts in these fields.

The global energy meeting focused on the topic of shale gas which we have followed interms of environmental and social risks that have been evident throughout the boom ofthe last couple of years. Given the lack of a regulatory framework in the US, there havebeen question marks regarding practices related to the proliferation of shale gas and itsimpact on environmental pollution. The key issues covered include water pollution and theuse of water, fugitive emissions contributing to air pollution, earthquakes and surface landdisruption. The concerns are not insignificant and have led to moratoriums on drilling insome states and have sparked intense public debate. On the positive side, the industrybrings job creation and enjoys political support.

From an investment perspective, the ESG issues in shale gas have relevance in terms ofthe costs of greater environmental regulation and whether margins can hold up in anincreasingly pressured environment. It also has a material impact on the prospects for theindustry in Europe. The International Agency recently published best practice guidelines byissuing the “golden rules for shale gas”. This is a response to the lack of a regulatoryframework and the IEA estimates an average 7% operating cost increasing to comply withthese standards. The opportunity areas we have considered include the supply chain forhealth and safety and cleaner technology, and the competitive advantage the betteroperators gain in terms of obtaining licences to operate.

The global healthcare meeting focused on a range of ESG issues in healthcare, includingaccess to medicines, product integrity, pricing policies and the regulatory issuessurrounding sales practices. Brokers, including Bank of America Merrill Lynch and UBS,

Company meetings and engagements

Remuneration Consultation / Proxy

Voting Related

Oxford Instruments, Persimmon, New Britain PalmOil, WS Atkins, DS Smith, Prysmian, SchneiderElectric, Credit Suisse, Laboratory Corp, Aviva,Headlam, Prysmian, Belimo, LSL Properties, FaroePetroleum, Barclays, WPP, Rank, Morrison’s,Standard Chartered, BG Group, Aviva, Bellway,Astrazeneca

ESG road show/ engagement BMW, Royal Dutch Shell, Bank of America, RoyalBank of Scotland, BP plc., Marks & Spencer,Antofagasta, BHB Billiton, Iberdrola, Lonmin,Deutsche Telekom, Tesco, Stratec Biomedical, VZHoldings, Grenkeleasing , Toshiba, Cobham, GKN,Melrose, Standard Chartered, Linde, Unilever,Sulzer, Andritz, Xstrata, Glencore

Mainstream meeting** Total, Xstrata, Glencore, Lonmin

Stock reviews G4S, Shire, Nelson Holdings, Apple, Danaher,Banpu, Jaiprakash, Metropolitan Bank, BDO,Infosys, Compass, Inditex, Red Electrica, PacificRubiales

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have both issued reports addressing sector issues such as obesity and disease preventionthrough vaccination. Both of these subjects support the theme of reducing governmenthealthcare bills. Indeed, emerging issues in the healthcare sector correlate with theMillennium Development Goals for sustainable development, which is increasinglyfocused on providing solutions that benefit both society and the economy.

Developments in Governance andResponsible InvestmentESG Research and the European CrisisWith the euro crisis at the forefront of the news, the real test of the weight given tosustainability strategies is whether companies continue to invest for the future.

Sustainable growth in terms of financial, environmental and social security, seems aninappropriate description of current events. The euro could be on the point of breaking upover debt and austerity measures, while extreme weather events, which could be relatedto climate change, such as the Thai floods in December last year, have become morefrequent, costing an estimated £83bn in 2010 alone (Munich Re).

Yet the idea of sustainable growth has been promoted by governments, which havecoupled stimulus programmes (following the 2008 financial crisis) with frameworks tosupport new technologies and investment in infrastructure. China’s green stimulus andAmerica’s focus on green jobs, as well as Europe’s continued focus on 20% carbonreduction (from 1990 levels by 2020) are examples of government support and therealisation of the need for sustainable growth.

Thus, an analysis of some of our long-term core holdings in Europe over the past fewyears is considered relevant to further understand the opportunities and the companiesthat are truly investing for long-term sustainable growth. Company dialogue has given anindication of the trends and enabled Threadneedle to review relevant indicators, includingratios, such as capital expenditure to depreciation and research and development to sales.

The review of our core holdings indicated that companies with strong stewardship(according to our ESG metrics) do not necessarily have greater investment in R&D as apercentage of sales or capital expenditure. However, the discussions with companiesindicate that investment continues in these areas and that it is paying off in terms ofrevenue generation and operational licences

Rio Plus 20 – The Future We WantUnderstanding returns on investment and including ESG factors into decision making wasa major theme at the Rio plus 20 United Nations Earth Summit in June 2012.

While the final text has been described as “weak” by NGOs such as Greenpeace, itlargely achieved what was expected and was an event where corporates showed trueleadership beyond governmental commitments.

The outcomes of the final text were broadly as follows:

Reconfirmed Agenda 21, which was set out in the 1992 summit and also theMillennium development goals (MDG), which world leaders continue to aim to reach by2015

Recognising that there has been “uneven progress”. Notably, over 1 billion of theworld’s population still live in extreme poverty

Decided to set up an inter-governmental UN structure for sustainability which hasmultiple functions, but primarily aims to oversee the implementation of the globalsustainability goals and to co-ordinate the UN bodies dedicated to different aspects ofsustainable development

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The text recognises the need for high impact sectors to be regulated by governments toact responsibly including: mining, chemicals and waste. It reconfirmed support forproviding education. Throughout the text the onus is on governments to draw up plans forprotecting people and the environment, support existing efforts, and encouragecollaboration between organisations.

In addition to public policy representatives, the Rio plus 20 conference was dominated bycorporates. Examples of corporates which benefit in economic terms from products andmanagement models, which also create social value, were abundant. Indeed, the UnitedNations Environment Programme (UNEP) issued their “Green Economy” reporthighlighting case studies from across sectors where new innovative products havebrought revenue, productivity gains and also improved the environment and humanwelfare.

The investor community was active to some extent, particularly in relation to sustainabilityreporting and the UNPRI and ICGN conference, which was also being held in Rio.Threadneedle is, in principle, supportive of the move towards greater transparency insustainability reporting and believes that the final text includes a positive statement:

47. We acknowledge the importance of corporate sustainability reporting and encouragecompanies, where appropriate, especially publicly listed and large companies, to considerintegrating sustainability information into their reporting cycle. We encourage industry,interested governments, as well as relevant stakeholders with the support of the UNsystem, as appropriate, to develop models for best practice and facilitate action for theintegration of sustainability reporting, taking into account the experiences of alreadyexisting frameworks, and paying particular attention to the needs of developing countries,including in terms of capacity building.

The investment implications will become increasingly apparent as plans are drawn up at alocal government level. We can potentially expect to see some regulatory developmentsin chemicals, mining and waste and a greater focus on revenue transparency in miners.These sectors are high impact and have long been a focus for the Governance andResponsible Investment’s team’s engagement activities. The emphasis on sustainabledevelopment and the Green Economy confirms the positive opportunity for sectors andtechnologies contributing to sustainable growth.

Governance & Public PolicyThe UK Bribery ActThe second quarter marked the end of the first year that the UK’s Bribery Act 2010 was inforce and although we have yet to see any significant prosecutions under the legislation, wehave seen a significant impact in our discussions with companies. The considerable initialuncertainty and concern surrounding the lack of guidance on key aspects of the regime hasbeen addressed, with various pieces of guidance and advice coming from the Ministry ofJustice, the FSA, the SFO and Director of Public Prosecutions, as well as organisations suchas the British Bankers Association, Transparency International, law firms and others. For themost part, the focus and attention that has been given to tightening up company policies andpractices, not just in relation to the use of agents, but in terms of facilitation risk and risksfrom outsourcing and acquisitions as a result of the Act has been clear. Companies appear tohave been thorough in their approaches as the SFO and FSA work through their existing caseloads and progress new cases under the Act.

Banking ReformJune saw the publication of the Government’s White Paper on Banking Reform, whichfollows up on the proposals of the UK Independent (Vickers) Commission on Banking thatwere published in September 2011. The government indicated its broad support for thoserecommendations in December 2011.

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The White Paper re-affirms that broad support and begins the development andconsultation process on:

(i) The scope of ring fencing (product prohibitions and exemptions, counterparty issues,the use of non-EEA entities; jurisdictional issues for service and credit agreementsetc.);

(ii) The ‘height’ of the ring fence (restrictions on large exposures and intra-grouptransactions; the requirements on pension funds; and tax issues etc.);

(iii) Capital requirements (a scaled, additional common equity tier 1 requirement of up to3% of risk weighted assets, in addition to the Basel III minimum common equityrequirements of 7% and any counter-cyclical buffer impose; implicitly dropping theadditional resolution buffer of up to 3% of risk weighted assets for UK-headquartered‘global systemically important banks’ that had been proposed; expanding the scope ofthe proposals on a bank’s primary loss absorbing capacity – 17% of risk weightedassets for banks whose risk weighted assets equal 3% or more of GDP - to includesubordinated debt currently in issuance that does not qualify as additional tier 1 or tier2 capital and, possibly, other forms of unsecured long-term debt instruments; limitingthe application of the requirements for primary loss absorbing capacity in respect ofnon-UK operations, etc.);

(iv) Bail-in requirements (where the UK will ultimately follow the emerging Europeanframework for resolution and recovery, but in the meantime appears to be re-openingsome of the issues resolved in Europe such as whether liabilities of less than onemonth maturity should be excluded from bail-in; whether banks might be required toissue a tranche of long-term debt that would be subordinated to senior unsecuredliabilities in insolvency and that could be bailed in prior to senior unsecured debt, etc.);

(v) depositor preference (confirms that that all deposits insured by the Financial ServicesCompensation Scheme rank ahead of unsecured creditors or creditors secured withfloating charges, even though this goes further than European proposals; and seeksviews on whether to extend this to pension funds, charities and local authorities forexample); the leverage ratio (the proposal for larger banks to have a Tier 1 leverageratio above the minimum 3% proposed in the European frameworks are beingdropped, etc.);

(vi) The promotion of competition (a review of barriers to entry or expansion for newplayers, current account switching, an Office of Fair Trading review of the personalcurrent account market; and a new FCA operational objective to promote competitionon behalf of consumers, etc.).

The consultation runs until 6 September 2012 and the government intend to have all thelegislative instruments and regulations in place by May 2015. Implementation is expectedto be in 2019, although some transitional arrangement may extend beyond that.

Academic and ESG ResearchAcademic and other research into ESG-related themes offers practitioners a useful insightinto the dynamics surrounding these issues and practices. As we are always keen to note,however, different approaches, time periods and samples regularly produce differentresults in these studies. Building on the themes we noted in our Q1 report, Q2 has seenfurther academic work from around the world drawing out various aspects of the potentialrelevance and value of corporate social responsibility for investors.

Set against a context of increasing interest and concern about natural resources, air andwater pollution, and social issues, A.Khaveh et al (May 2012) examined the relevance ofvoluntary disclosure in Singapore, where environmental and social performance anddisclosure are not mandatory. The research found a positive and significant relationshipbetween companies’ environmental and social performance disclosure and shareholder

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wealth in terms of both dividends and share prices. While it is important to consider thecontext in which the study was undertaken, the results serve to emphasise that effectivedisclosure around corporate social responsibility should not be underestimated. Becchettiet al (April 2012) studied the quality of analysts’ forecast on a large sample of US firmforecasts across 1997-2004, finding that the corporate social responsibility practice andassociated transparency reduces information asymmetries. They also showed reducedvariability and the absolute value of the earning forecast bias, even after controlling forstandard regressors and year, industry, and firm/broker effects. In particular, they note therole played by effective corporate social responsibility in minimising the incidence ofcontroversies and conflicts with stakeholders. Set against this context, this quarter wealso caught up on the empirical research undertaken in Spain by Prado-Lorenzo et al (Feb2012) that illustrates the value in shareholder engagement in this area. They studied theeffect of shareholder engagement on the disclosure of corporate social responsibilityinformation, finding a significant positive effect.

The relevance and importance of this, however, go beyond just the quality of disclosure.Manyang et al (May 2012) studied a large sample of US mergers to examine the relevanceof corporate social responsibility (CSR) . They found acquirers with better CSR realise bothhigher announcement returns, larger increases in post-merger stock returns and operatingperformance, greater reductions in post-merger cost of capital, and smaller reductions inpost-merger number of employees. In addition, mergers involving these companies failedless frequently and evidenced fewer challenges from antitrust authorities. This echoedwork by A.Ng & Z.Rezaee (April 2012), which examined the effect of sustainabilityperformance disclosures on corporate cost of capital. In a more general analysis theyfound that sustainability disclosures, pertaining to the economic, ethics and environmentperformance, unambiguously lower both the cost of debt and equity, while disclosuresregarding social and governance performance only lower the cost of debt.

We have examined a number of studies around the role and value of corporategovernance in Q2, but particularly noteworthy was the research published by GMI (June2012) on the effects of combining the CEO and Chairman’s role in a single individual(Duality). Duality has long been a contentious and emotive issue, not least because of thenot insignificant egos that are often involved. However, the separation of the roles of theChairman and the CEO is generally regarded as best practice by investors. Studying 180US mega-caps ( with a market capitalization of $20 billion or more), GMI found thatalthough companies with duality produced better short-term returns, five-year totalshareholder returns were nearly 28% higher at companies with a separate CEO and chair.At the same time, the average pay of the combined Chairmen and CEOs was 64% higherthan for other CEOs and +51% higher than the combined pay of separate chairmen andCEOs. This struck us as interesting coming as it did after the work by A.Brink et al (April2012) on the effect of financial incentives on excessive risk-taking behaviour. Interestingly,the enduring effect of powerful financial incentives and the implication that once a firmcombines the roles and gears up the incentives, this later study suggests that reversingthe process will not significantly decrease excessive risk taking in the short-term,reflecting a resulting cultural change that accompanies the move.

Important Information: The research or analysis included in the report has been produced by Threadneedle for its own investment management activities, may have been acted upon prior to publication,and is made available here incidentally. In some instances the information contained in this note, other than statements of fact, may have been obtained from external sources believed to be reliable, butits accuracy or completeness cannot be guaranteed. Any opinions expressed are as at the date of issue, but are subject to change without notice. Threadneedle is a brand name, and both the Threadneedlename and logo are trademarks or registered trademarks of the Threadneedle group of companies. Threadneedle Asset Management Limited. Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorisedand regulated in the UK by the Financial Services Authority (“FSA”). Registered in England and Wales, No. 122194. Threadneedle International Limited. Registered in England and Wales. Registered no.2283244. Confirmation of this can be found at the FSA’s website www.fsa.gov.uk

Issued 07.12 | Valid to 10.12 | T3951

For more information on SRI product opportunitiesor our approach to integrating Governance and ResponsibleInvestment, please contact Cathrine de Coninck-Smith atcathrine.deconinck-smith@threadneedle.co.uk or +44 (0) 20 7464 5211.