Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 2 -- Evidence
Ottawa, Tuesday, April 30, 1996
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:00 a.m. to examine the state of the financial system in Canada as it relates to corporate governance.
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, we are here this morning with our last witness on our study on corporate governance. He is Mr. Bruce Malcolm, of Alexander & Alexander, Reed Stenhouse.
Senator Angus: Mr. Chairman, I should like to declare my interest just so that committee members are aware of it. I do not think it affects anything. However, I am on the board of directors of Alexander & Alexander, Reed Stenhouse.
The Chairman: Mr. Malcolm, I should like to thank you for coming to talk to us about D&O insurance. It would be helpful if you would summarize what you have presented to us in written form, as well as make any additional comments you would like to make, after which we will proceed to ask you some questions.
Mr. Bruce A. Malcolm, Director, Alexander & Alexander, Reed Stenhouse: Thank you, Mr. Chairman. I watched a number of your committee hearings on television. I was intrigued by the subject of directors' and officers' liability insurance. It is a subject in which I have been interested for more than 20 years. The comments from the witnesses from whom you heard seem to fall into three areas: availability of directors' and officers' liability insurance; the cost of such insurance; and what coverage was provided.
The Chairman: Does your firm provide D&O insurance?
Mr. Malcolm: We are brokers. We do not ourselves provide it.
The Chairman: I should have asked you that question slightly differently. Is one of the products you sell D&O insurance?
Mr. Malcolm: That is correct. I have tried to address those three subjects in my background paper. I had read somewhere that in the Companies Act of 1869, directors were made responsible for employee wages. Mr. Macdonald mentioned this when he addressed the committee. I was intrigued by that because some 120 years later this subject has become very significant.
D&O insurance originated with Lloyd's following the 1933 and 1934 acts in the United States. Some policies were issued in the 1930s to companies such as Gaf and Federated Stores. They were typical old Lloyd's policies with cumbersome wording. The difficulty was that there was no harmonization between U.S. federal and state law. In other words, in some states a corporation could indemnify a director for damages but not for defence costs. The wording was an attempt at providing liability coverage.
Subsequent to the war, the perceived need for coverage expanded in the United States. There was an interim period when not much happened. However, around the late 1950s to the early 1960s, there was a new interest in D&O insurance. A number of U.S. insurers began writing D&O insurance in the early 1960s, although Lloyd's remained the leader in the risk class. In 1966, one consultant said that there was no need for directors' liability in Canada because directors did not have any liability. Significantly, in 1982, savings and loan companies in the United States were deregulated. At the same time, the U.S. government increased deposit insurance, first from $25,000 to $40,000 and then to $100,000. Between 1982 and 1988, more than 500 savings and loan companies went bankrupt in the United States. The cost to the U.S. government so far, I believe, is around $250 billion which will be spread over 30 years.
At the same time, in the early 1980s, there were leveraged buy-outs. The minority shareholders who were on one side or other of the leveraged buy-outs felt oppressed and sued the directors and officers. In the mid to late 1970s here in Canada, there was an explosion of legislation imposing different kinds of liabilities on directors at both the federal and the provincial levels. That, together with publicity surrounding D&O claims in the U.S., sparked an interest in directors' and officers' liability in Canada. One U.S. company alone has paid nearly $1 billion in D&O claims in 10 years, all arising out of the savings and loan situation.
Senator Angus: Is it still in business?
Mr. Malcolm: Yes.
Between 1975 and approximately 1980, the demand for D&O insurance in Canada increased. The existing market in Canada for D&O insurance was basically non-domestic. You had to go to London, New York, Los Angeles or Chicago to negotiate with an insurer. There was no resident, domestic insurer with whom you could negotiate.
The existing non-domestic market could not handle the demand that arose. Therefore, new companies got into the D&O insurance business. Kansa, Inapro, Encon, which is a contract agency here in Ottawa, and particularly Chubb, established themselves. AIG, which is one of the leading D&O insurers, opened offices in Toronto and Montreal. By late 1982, there was a viable D&O insurance market in Canada.
Barely three years after the establishment of this market, the D&O loss experience in the United States became unacceptable both to direct D&O insurers and to reinsurers. The fledgling Canadian D&O insurance market almost collapsed. Kansa and Inapro withdrew. CNA and Harbor Insurance retired back to the United States. Crum & Foster stayed more or less as a post office box. Encon stopped writing anything that had a U.S. exposure.
Therefore, in late 1985 we were left with three basic D&O insurers in Canada -- AIG, Chubb and Lloyd's -- and Chubb thought twice about staying on.
In 1986, CODA, the Corporate Officers and Directors Association, was formed. It is a policyholder-based, captive insurance company in Bermuda. It was set up to provide directors' and officers' liability insurance basically for corporations in the U.S. where that type of insurance had become hard to find and very expensive. There were attempts made to set up a similar captive in Canada; however, there was not sufficient interest here.
The market opened again in about 1986. Premiums for D&O insurance peaked in 1987. The Guarantee Company of North America started. It is now called London Guarantee, and it used to be called Wellington Guarantee. Reliance came into the market. AIG, Chubb and Encon, all of whom had continued through the tough years, expanded their facilities. Lloyd's was, and still is, a market for D&O insurance. Since 1987, Cigna has also returned to the market, as has Liberty and Boreal, and others.
Today, you can negotiate policy wordings. You can develop D&O coverage for initial public offerings. However, because there are about 16 or 17 companies writing D&O insurance, you cannot guarantee that any company which wants D&O insurance can get it any more than you can guarantee that a bank will make a loan to any unsecured creditor.
Over the last 10 years, the publishing industry on directors' and officers' liability has expanded tremendously. The big thing in U.S. claims at the moment is class action securities claims.
The publication which I have in my hand comes out monthly. It lists all the class action securities claims that are currently ongoing in the U.S. It tells all the sins of the directors which are being alleged in those cases. I draw this publication to your attention since, undoubtedly, you saw the photograph in the Globe and Mail in February, which shows two attorneys and a plaintiff jumping for joy over the first successful class action suit in Canada. That article states that no money down is needed and that the work is done on a contingency fee basis. I believe there are a couple of cases in line for securities claims in Canada. I sincerely hope that we will not wind up with a situation similar to the American one in Canada.
It appears to me that the difficulty with the class action suit is that one can make an allegation and the defendant then has to supply two or three years of corporate records to defend himself. Also, his executive officers are tied up in attending court proceedings, et cetera.
I could give you an idea of the differences in the various D&O insurance policies, if that would be of interest, but my best example of the nature of the differences is that half the market spells defence with an "S" and the other half spells it with a "C". It starts there, and they do not agree on anything else.
Senator Stewart: I am glad that the witness used the word "sins" because it provided me with a term to use in asking my question. You have established the history of D&O insurance. What categories of sins are alleged? Let us consider directors first, and then officers. Would you tell us what sins are alleged and where those allegations have been found to be valid to the point where the insurer has had to ante up?
Mr. Malcolm: I should have mentioned that I attached to the to the end of the circular that I gave you a selection of claims against directors and officers.
Senator Angus: You list the companies that are involved but you do not list the issues.
Mr. Malcolm: Let me expand on this. This list is from a collection of newspaper clippings. Some of these are small claims; some of them are significant claims. The list is typical of the Canadian experience in that the majority are claims following a bankruptcy of a corporation. There are a few claims I have included out of interest because a judge has found an active director not responsible for taxes following a bankruptcy. There are a few cases which are class action lawsuits.
The Newbridge case is a class action lawsuit for misrepresentation. The value of their shares did not go according to what the analyst had said, so they were sued in a class action lawsuit in the United States. The Cott case is also a class action lawsuit in the States. The Loewen case is a one in which Loewen could have settled a contract dispute at a certain figure but they did not, and the plaintiffs were awarded, in Mississippi, I believe, some $500 million. The share price dropped, and a claim has been made against the directors and officers. I happen to know which company is insuring that one, and they are carrying a policy limit reserve on that particular claim.
Senator Angus: They settled the case.
Mr. Malcolm: I should probably not be commenting on that because I do not really know for sure, but it is a substantial claim.
There are several environmental claims in this list. There probably would not be any coverage there, but there might be if someone had bought an extension to the coverage that provides pollution defence cover.
Senator Stewart: You are referring to, in a sense, the facts. In the case of the directors, is their sin, to use that word again, that they did not exercise due diligence?
Mr. Malcolm: It seems to me that it can be many things, but I would hesitate to use the word "sin" because, from an insurance point of view, the policy covers any matter that may be claimed against them. It does not even require any wrongful act. It is any matter that may be claimed against them. In class action suits, the allegation is nearly always a misrepresentation by a director or an officer.
It is fairly clear from the legislation that directors carry a far greater burden than the officers, except for the chief executive officer.
Senator Stewart: I will ask a question prompted by that last comment. I have the impression from some of the evidence we have heard that, in many cases, a chief executive officer, one way or another, dominates the board of directors. It would seem that, at least in those cases, it is rather unfair that the directors should be the ones who are held liable and therefore would need insurance rather than the chief executive officer. Just now you did say, I believe, that when you speak of the officers, you are exempting the chief executive officer.
Mr. Malcolm: The policy covers directors and officers.
I learned a tremendous amount about directors and officers from listening to your hearings. Someone said one size does not fit all, and it is fairly clear that the situation is different in larger corporations. One of your witnesses said that it is not the directors who should be responsible, but the officers.
I agree with you; there is no parity in the burden.
Senator Angus: Mr. Malcolm, I add my words of welcome to those of the chairman. It is good of you to appear. I gather your visit was provoked by the exposure our corporate governance hearings had on the CPAC channel.
Mr. Malcolm: That is correct.
Senator Angus: Are you retired now, or what is your role in the insurance business presently?
Mr. Malcolm: I am thinking about retiring.
Senator Angus: There is nothing better than coming around the Senate. It is good to see you here
Senator Stewart: You speak for yourself when you say this is the place to retire.
Senator Angus: I did not say that. You must be sensitive. It is an interesting place for a gentleman such as our witness to come and learn things.
Mr. Malcolm, as you saw on the TV coverage, and as we heard from the witnesses, directors, and indeed many others, seem to feel that the liability on directors is open-ended and that it is very hard to assess your exposure. It is kind of a blank cheque. Persons joining a board of directors of a company are often unable to delineate precisely their exposure. Basically, their net worth is on the line. We heard many witnesses saying this is an inhibiting thing for companies because in some cases it restricts their ability to recruit directors, although we have heard contrary evidence on that.
We also heard that there should be some kind of cap, or at least a defence written into the law, so that there is some reasonable way for a directors, as long as they act in a duly diligent fashion, to restrict their exposure. That includes the archaic provision of the law going back over a hundred years under which the wages of employees are an absolute liability, without any defence. You can have been as diligent as possible, but you still have to pay.
Do you feel, and is it the gist of your evidence, that there is adequate insurance available to cover all these unknown liabilities?
Mr. Malcolm: Insurers have no greater insight into what a director's liability actually is than anyone else. They are struggling to provide a policy that provides coverage for certain things.
They do provide coverage for the directors' responsibility for six months' wages. I think it is two months' wages in B.C. and six months' wages federally. That can be calculated. I believe one of your witnesses calculated that the Hudson's Bay's directors' responsibility for salaries and benefits was $600 million. In Canada, a company of that size can now buy $500 million or more of directors' and officers' liability insurance.
Senator Angus: What would the price be for that, roughly? Would it be prohibitive?
Mr. Malcolm: A company with $3 billion in assets would probably pay somewhere around, I would guess, $250,000 or $300,000 for the first $25 million of coverage. It goes down from there.
It is interesting to see the way the D&O market works. In 1985-86, you could buy a primary policy for $25 million and you would perhaps pay $200,000 for it. The excess underwriter would come along and say, "I will do 25 on top," but the market was tight and you had to pay $200,000 for the extra 25. In my opinion, in 1985-86, the D&O underwriters were gouging. You could tell by how much you paid for the excess.
Senator Angus: Did you say they were gouging?
Mr. Malcolm: In my opinion, they were gouging at that time because there was no market. It was not the Canadian directors who were causing the shortage of market; it was the problem in the United States.
The market then got into the period during which for coverage over 25, you paid between 50 per cent and 60 per cent. If you paid $100,000 for the first $25 million, you paid between $50,000 and $60,000 for the next. In the present market, you will pay between 35 and 40 per cent.
In today's marketplace, there are alternatives. You can negotiate. You can expand your coverage. None of the policies are the same. The policies of all 18 insurers are different. You have to know what the differences are, and you have to work in trade-offs. One market will not touch any liability arising out of asbestos. Another market does not exclude it specifically, but it might be excluded by the pollution definition.
The area of taxes provides an interesting example. In all D&O policies, and it does not matter whether you are talking about CODA or any of the others, there is a broad exclusion covering anything that is uninsurable at law. Regretfully, only the lawyers know what that is.
Senator Angus: The thrust of your presentation seems to be that, as members of the Senate Banking Committee about to issue a report on corporate governance issues, we should not be worried because there is adequate D&O insurance available in Canada. I should like to explore that with you because I think that absolutely the opposite is the case.
Mr. Malcolm: I said that regarding wages. D&O policies cover a director's statutory obligation for salaries and wages following a bankruptcy. You can calculate that. In one of the cases where the board resigned, I believe they were carrying D&O insurance with a $15 million limit and they had a calculated $26 million exposure for salaries, so they were short.
In the Interlink case, the press release mentioned that they were carrying directors' and officers' liability insurance with a limit of $15 million, whereas their calculated liability for salaries was $14 million.
There is a difficulty when you come to pollution because no underwriter wants to be involved with pollution. It is a very limited market. Where directors become liable in pollution cases, there is very limited coverage.
Coverage for taxes is also a difficult area, because while some policies do not have a specific tax exclusion in the definitions, there is still that exclusion for things that are uninsurable at law. There are a few cases in the U.S. where the court has decided that taxes are uninsurable at law. They are against public interest, even for the directors. You cannot expect the insurance industry to come along and provide coverage which the court says is uninsurable at law.
The Chairman: If you as a director are told that your company has D&O insurance up to some limit, am I correct in inferring from what you said a minute ago that while that limit will include wages, it may not, for example, include environmental issues? Does a D&O insurance policy only protect directors from certain of the things for which they are liable?
Mr. Malcolm: That is correct.
Senator Angus: There are exclusions.
The Chairman: I would be willing to hazard a guess that many directors do not know that.
Senator Angus: I think you would be surprised. Any director worth his salt usually inquires if there is D&O coverage, and then he should see the policy.
The Chairman: I understood the limit, but I did not realize that the limit also carried specific exclusions on it.
Mr. Malcolm: D&O policies are written with a very broad insuring clause. I have indicated that to you in the notes. You have a number of very specific exclusions, one of which is the nuclear exclusion. They do not need to exclude nuclear liability because the Nuclear Liability Act takes care of most cases except for universities and power corporations. They exclude prior and pending litigation. You will not get an insurer to pick up something that has already started. They exclude bodily injury and direct property damage claims because those items would normally be covered under a general liability policy. They have an absolute pollution exclusion.
Following the Exxon Valdez incident, insurers came out with a derivative pollution clause under which you would be covered if, following a pollution incident, the share price were to drop and you face a shareholder derivative action. You can get a certain amount of pollution defence cover. However, for absolute pollution coverage, the insurance coverage is limited.
Senator Angus: That is my point, Mr. Malcolm. I am not being critical. You are confirming what I believe is happening in the marketplace and what other witnesses have said. One witness or researcher told us that there are some 124 statutes in Ontario alone that impose statutory liability for one form of pollution or another.
You just said that you cannot expect the insurance industry to cover everything, and I fully agree with you.
You said one insurer paid out $1 billion U.S. over five years.
Mr. Malcolm: No, nearly $1 billion over 10 years.
Senator Angus: That is a lot of money and it would require an awfully large premium. You mentioned the case of Hudson's Bay where there was an estimated exposure of $600 million for only six months of wages, and you talked about a cost of $350,000 for the first 25 million, never mind 600 million. I can tell you that the cost to get insurance for 600 million, in a market where, as you have already said in your brief, most capacities are around 100 million, will be prohibitive. I put this to you to see if you agree: Today there is a modicum of D&O available, at a high price, but it does not go anywhere near covering you for the full exposure, this unknown exposure, that directors are taking on. My bottom-line question to you is: Would you not agree that, based on that situation in the insurance market, there are grounds to have some kind of restriction on a director's liability, be it a cap or a due-diligence defence, as Senator Stewart was suggesting?
Mr. Malcolm: We are almost back where the U.S. was in the 1930s where there is absolutely no harmonization. I think it was Mr. Crawford who said his staff had put together 42 pages just listing the statutes that impose a liability on a director, and some of them are in conflict, so that if you abide by one, you are in conflict with another. I do not think that is the insurer's fault, with due respect. I believe that the fault lies somewhere else.
Senator Angus: Possibly with the legislators, because we have not provided restrictions. I agree that an insurer should not be expected to cover every unlimited possibility. By the same token, if you were asked to go on the board of Ford Motor Company and have no insurance, how secure would you feel with the plethora of responsibilities that you would face?
Mr. Malcolm: If you are going to buy D&O insurance, which many more companies do today than did formerly, you should be aware of what the coverage is and what trade-offs you have taken, because you cannot get perfect coverage from any one insurer. You work in trade-offs with every insurer, and there are significant differences between one insurer and another.
Senator Angus: Let us move to a couple of other points. On the question of capacity, what you have said in your brief is accurate, that there is an element of interest in Canada by a number of local, domestic insurers, some American insurers, and even Lloyd's, to the extent that Lloyd's can still afford to pay even one claim these days. Is there any interest in, for example, the London company market or in the European market, by some of these big, deep-pocketed insurers?
Mr. Malcolm: I would expect they reinsure in a number of cases. As you well know, companies lay off certain risks. Many from the London company market are represented here, such as Royal or Continental or the Guardian.
Senator Angus: Through Encon.
Mr. Malcolm: They all provide a certain amount of D&O insurance in the small, not-for-profit situations such as for condominiums and school boards.
Senator Angus: Where there is really almost no risk.
Mr. Malcolm: If you look in any of the books on the subject, you will see that many of them mention the case of the swimming club out in Saskatchewan where the directors got caught for failing to deduct taxes at source on an employee. That was a not-for-profit organization.
Senator Angus: On the question of capacity, you say the companies that are in the field here in Canada are starting to offer capacities up to, say, $100 million.
Mr. Malcolm: No. Most companies have a $25 million limit, and there are about 10 companies that can put up 25 million and some that can put up 15 million, so you can build up with licensed Canadian companies.
Senator Angus: Is that per risk?
Mr. Malcolm: It is an aggregate limit per risk.
Senator Angus: One company might provide 25 million for a number of insureds, is that correct?
Mr. Malcolm: No. They provide it for a company. In other words, they write one company at a time and they will put up their $25 million limit, so the company can build up, with Canadian licensed insurers, some $250 million. Then it would have to go off shore to insurers such as ACE, XL or CODA, and it could probably build up another 250 million or 300 million on an excess basis. However, at the very top end, the company is probably only paying 5 per cent of the primary premium for that top 25 million or 50 million.
Senator Angus: Would you agree that where a director would need the insurance most is in cases where the companies are the shakiest? With most blue chip companies, there is never an issue that wages are not going to be paid or that they are going to go belly-up. The need is in companies that are already in financial trouble.
Senator Stewart: And they cannot afford the insurance.
Senator Angus: That is my point. My experience has been that when it is really needed, you cannot afford it. What happened with PWA and Westar and a few others that you mentioned in your brief, is that those companies ran out of cash, they had a negative net worth and had effectively hit the wall, and the directors said, "We are walking because there is a statutory liability that we have quantified at $35 million. Unless somebody comes up with a trust fund and puts that money aside, either out of the company's remaining assets or from some benevolent union that wants to see the company stay in business to protect us, we are walking." They cannot afford the insurance.
I happen to know what the price would be to have proper insurance. It is prohibitive. I know of one large public company with assets in Canada of $7 billion that has D&O cover of 85 million. The cost of that is prohibitive, and the 85 million does not even go an inch towards giving security to the directors for their liability. So I am suggesting to you that while there is a dabbling around by insurers, offering D&O insurance to school boards, hospitals and so on, there is really no market.
Mr. Malcolm: There is a market for it, and the market should buy it when it is not in financial difficulties because, if you go to an insurer when you are having financial difficulties, that is the hardest time to negotiate and get the best rates and conditions. Certainly in Canada, the broad experience with D&O insurance is following bankruptcy. However, we do have our share of wrongful-dismissal suits. We do have the class-action suits, which are paid by insurers. There have been a number of cases of the directors being reimbursed for wages, and for taxes, so, yes, there has been coverage, and certainly, if you go by the U.S. experience--
Senator Angus: You are not advocating that, are you?
Mr. Malcolm: No.
Senator Angus: Neither are we.
Mr. Malcolm: I am not advocating that, but underwriters have paid an awful lot of money on behalf of directors and officers.
Senator Angus: That is why they do not want to be in the market. Where you can be helpful to us -- and I think you are being helpful -- in our role as public policy makers or advisers, is with the following question. Do you not agree, as I was suggesting earlier, that there is perhaps a sound public policy reason to put some kind of a restriction on the open-ended liability to which directors of public companies in Canada are exposed? As long as there is due diligence in appointing the directors in the first place, so that boards are composed of people who can add one and one and read a balance sheet and know what "derivative" means, and as long as there is a due-diligence defence, and maybe one or two other restrictions on their liability, then insurers might feel that there is an orderly corporate environment and they might be prepared to provide a coverage for that kind of liability at a reasonable price.
Mr. Malcolm: I am sure that you can negotiate with them anything that improves a director's position. Personally, I find it difficult that a director does not have a due-diligence defence, but that is the way it has been in the law for a long time.
Senator Angus: We have been asked to recommend possible changes. Do you think that would be a good change?
Mr. Malcolm: Personally, yes.
Senator Angus: Thank you. That is what I was hoping you would say.
Mr. Malcolm: I have no problem with that. Then you have to find the money somewhere else.
Senator Angus: What do you mean by "the money"?
Mr. Malcolm: If you cap the liability of directors or if you give a defence to the directors, then --
Senator Angus: Perhaps it would discourage these stupid suits. These are just lawyers. You have referred to the name of one of the firms in your brief. They just cast their fly in the waters and hope for some big fish: "Here is a rich guy; let's get him."
Senator Stewart: This is very interesting.
I have two different kinds of questions. First, you have your list of a selection of claims against directors and officers reported in the news media, and I gather this is in Canada.
Mr. Malcolm: Yes.
Senator Stewart: I am trying to understand the kinds of claims that might come up. We talked a bit about that earlier. I want to go back to that, but I want to ask about kinds of claims based on the source of the claim. Presumably in some cases we have shareholders making the claim.
Mr. Malcolm: Yes.
Senator Stewart: In other cases, it is what I will call others, such as persons owed wages and salaries or perhaps members of the general public.
Mr. Malcolm: Yes.
Senator Stewart: Do you have enough knowledge of the history of these claims to tell us, using perhaps this list or some other, how it breaks down? How often is it that shareholders say that the directors and officers did not perform properly?
Mr. Malcolm: I went through my collection of newspaper clippings, and I sorted out the ones that applied to Canadian companies. I also have quite a collection regarding U.S. companies.
Cornerbrook Pulp & Paper, from last week, is a claim against the directors for pollution.
Senator Stewart: However, it is not made by the shareholders.
Mr. Malcolm: That is made by a government body. Panamerica is another pollution claim. Domtar is a claim by a former CEO against a director for wrongful dismissal. Confederation Life is a bankruptcy. Peoples Jewellers is a bankruptcy. I do not remember the details of Vidéotron. Royal Trustco is a bankruptcy. Seabright is a contract dispute which dragged in the shareholders. Loewen was brought by shareholders following that funny contract in Mississippi. STN, as I recall, is a bankruptcy. In Canadian Commercial Bank, the fight with the insurers is still going on, as far as I know.
Senator Stewart: What you have said has been helpful because it suggests that there is a considerable diversity. The question I am leading up to is this: Is there a basis for a distinction between the shareholders, on the one hand, and others making a claim? Could it be argued that the shareholders bought in and they could have gone to the annual meetings, and that, in a sense, they did have some control, at least theoretically, over the directors?
Mr. Malcolm: The Newbridge Networks case is interesting. Approximately a year ago they made an announcement on a Friday that their nine-month result or their three-month result would not be spectacular but only very good. There was a holiday on the Monday in Canada, so the stock market in Canada was closed. However, the market in the States was open. Because this statement had been made, it put those who traded on the Canadian market at a disadvantage, and the price dropped 35 per cent, I believe. That immediately resulted in a class action suit. What did the directors do wrong? If you read the paper about that particular case, before the directors made that announcement on the Friday, they checked with their inside attorneys, they checked with their outside attorneys, they made a statement, and they were still sued.
Senator Angus: They would not be found liable, though.
Mr. Malcolm: You have to defend yourself, and you wind up with having to prove something. It cost the plaintiffs nothing to take a suit, but the directors will have to provide three truckloads full of the last three years' corporate records, plus these suits tie up your executive, and so you settle. In effect, that is what all these cases are about. There are many of them listed here. They are all based on allegations of misrepresentation. Most of the time, it is just because the share price dropped. The directors did not do anything wrong in these cases.
Senator Stewart: That is an interesting example and a important generalization based on it.
I should like to go back to something you said in your notes. I am trying to understand the history which you give us here. On page 1 of the notes, you are describing the situation from mid 1984 to 1987. You say:
Liability market tightened in general and D&O market hit with the collapse of Savings and Loans (following deregulation in 1982) and claims flowing from the leveraged buy-outs of the early and mid-eighties.
Claims flowing from the leveraged buy-outs, as I understand, and tell me if I am wrong, is a distinct category from the claims that flowed from the collapse of savings and loan companies following deregulation in 1982.
Mr. Malcolm: That is correct, yes.
Senator Stewart: Could we then focus on the impact of the collapse of savings and loans following deregulation? I will tell you what I am trying to get at here. The suggestion here, perhaps unintentional, is that if that deregulation had not taken place, then the collapse would not have taken place, or at least it would not have been as severe as it was, and that in turn would have reduced the number of claims. Is that a fair line of reasoning?
Mr. Malcolm: Basically. When the government in October 1982 deregulated the savings and loan industry, they and thrift companies moved out of simple homeowner mortgages and got into the field of any speculative investment. The Phoenician Hotel in Phoenix is a monument to Charles Keating. The savings and loan companies lent more and more money and then collapsed. Some 500 savings and loan companies collapsed, which triggered all kinds of claims against directors.
Senator Stewart: There seems to be an argument here which is implicit. I am trying to discover if it is an argument that you want to make. You seem to be saying that if that deregulation had not taken place, then these catastrophic events would not have happened.
Mr. Malcolm: First, the government increased government-backed insurance. They took it from $25,000 to $40,000 and then to $100,000, all of which would be covered by the taxpayer. You then had this expansion of savings and loan companies into areas in which they should not have been going.
Senator Stewart: Should the government have prevented them from going there?
Mr. Malcolm: The regulators tried. The story "Charlie's Angels", the five senators who backed Mr. Keating, is quite fascinating. It was only in 1989 that the savings and loan companies were brought back under control.
Senator Stewart: Senator Angus, the question which is haunting me is this. On the one hand, we will hear an argument made to get government out of regulation and to let the market operate. On the other hand, people will say, "And nobody should lose money because some way or other either the taxpayer or the insurance industry should pay for disasters, whether they flow from the failures of the directors or from something else." I suppose the practical solution is some sort of a balance. However, I want at least to understand the problem.
Senator Angus: Do you mean in terms of insurance or in terms of regulation of financial institutions?
Senator Stewart: In terms of both because it is probably a balance.
Senator Angus: With respect to the savings and loan situation, the report which we issued after the Confederation hearings was about striking a balance just along those lines. In the United States, the regulator either did not have the powers that we are now trying to give to OSFI through Bill C-15, or it did have the powers and was asleep at the switch. I think the witness is saying with respect to Charlie and his angels, the fox was in the chicken coop in Washington. That would never happen here.
Mr. Malcolm: It did though. It happened in Alberta.
The Chairman: Are you referring to Principal Trust?
Mr. Malcolm: Yes.
The Chairman: That is provincially regulated.
Mr. Malcolm: In that case, I believe the regulator was given early retirement or downsized. We are not immune to that in Canada. I believe in balance. There has to be balance.
The Chairman: In your document you state two things which surprise me. The first is that over the last decade, premiums for D&O insurance have been declining by 5 per cent to 10 per cent per year. That surprises me, given the difficulty that directors feel they have had in getting insurance, and given the perception expressed by directors on various company boards, that the cost of D&O insurance is rising. You state that the reality is that premiums have been declining. Why are there those two different pictures?
Mr. Malcolm: Premiums peaked in 1987.
The Chairman: I want to be clear. You also say that the cumulative total amount of premiums paid for D&O insurance in Canada has remained relatively stationary for the last four or five years.
Mr. Malcolm: Please bear in mind that there are no statistics on that. The people who offer statistics on directors' and officers' liability are Wyatt and, I believe, the Conference Board.
The Chairman: You say the data are not reliable, for the reasons which you describe, is that right?
Mr. Malcolm: This is from 1991. As I understand it, there has not been enough funding to do another study since that time. The estimate within the industry is that there is approximately $100 million of premium. That has stayed fairly constant.
The Chairman: Let me set that issue aside. You also say that premiums have been declining reasonably steadily over the last decade.
Mr. Malcolm: With the last four to six renewals, you would expect to get something off the renewal, either the primary or the excess. As I mentioned, the excess underwriters really worked their premium when the market was tough.
The Chairman: Now I have a mathematical problem. Let us say I have a declining premium in the face of increasing risk from such things as class action suits. I do not think anyone can doubt that the risk of those is increasing. It would seem that the only way the industry can survive under those circumstances, if it is allowing the premium to decline, is by excluding the issues that are causing the greater risk. We all know that as risk goes up so do premiums. If premiums are going down and risks are going up, perceptually, there is a disconnection somewhere. What is happening?
Mr. Malcolm: Directors' and officers' insurance is a perception risk, in the sense that the liability was always there but it was only rated in 1975 when suddenly everyone in Canada wanted the coverage. I have already argued that the reforms in the United States have improved the risk, and therefore one ought to be able to negotiate premium.
The Chairman: You keep coming back to the U.S. and yet we are talking about Canadian premiums. If I am a Canadian firm doing business strictly in Canada, then the insurance policy you sell me does not have to take into account any risk in the United States because I do not do business in the United States. Is there a huge difference between a firm buying that kind of policy versus a firm buying an identical policy, but because it does business in the states the insurer has to take into account U.S. risk?
Mr. Malcolm: He automatically takes into account U.S. risk. The premium would be higher for the risk that is exposed to the U.S.
The Chairman: Can you give me an order of magnitude higher, please?
Mr. Malcolm: If you take the same company and the same policy between a U.S. client and a Canadian client, the Canadian premium will be between 50 per cent and 60 per cent of the U.S. premium. If you are talking about a Canadian company that has an exposure into the U.S., then you start asking questions such as: What kind of industry is it in? Is it in high tech? Is it on Nasdaq? Is it on the New York Stock Exchange? Does it have radical growth? You will pay more because you are exposed to the U.S., but your premium will not be as high as it would be if you were a U.S.-based company. It would be between 60 per cent and 80 per cent.
The Chairman: I want to understand that increased risk. Can you give me a breakdown with respect to that increased risk? I presume part of it is due to class action suits.
Mr. Malcolm: Yes.
The Chairman: Are there other factors? My sense is that the environmental risk is about the same. Many of the other risks are inherently the same. Is it the problem of class action suits that is causing that, as you said, roughly 40 to 50 per cent increase in premium between the U.S. company and the Canadian company?
Mr. Malcolm: Loewen, as an example, did not start out as a class action suit but as a contract dispute. By and large, Canadian underwriters prefer not to become involved with that. They do underwrite U.S. exposure.
The Chairman: The problem involves more than class action suits. It is with the U.S. judicial system in general.
Mr. Malcolm: Yes. That is the case with product liability or any other form of liability insurance.
Senator Angus: Including professional indemnity?
Mr. Malcolm: Yes.
The Chairman: It is the U.S. system generically as opposed to a specific feature.
Senator Angus: One example is insuring law firms for professional liability. A good firm in New York would be paying about $1600 U.S. per lawyer, and a comparable firm in Montreal with a good broker would be paying around $500 Canadian per lawyer. It is more than three times the cost.
The Chairman: In the paper you sent us, you talked about knowing of a firm or firms facing a series of claims, where you said they reserved against the claim to the maximum amount of the face value of the policy.
Mr. Malcolm: Yes.
The Chairman: I was not clear whether that is a claim that the courts have awarded or whether that is a claim still currently under litigation. Are there cases in Canada where the actual amount ultimately awarded by a court exceeded the maximum amount insurable under the policy?
Mr. Malcolm: There is a difficulty there. First, the company to which I referred advised me that they have five policy limit loss reserves. That could be $5 million, $10 million, anywhere up to $25 million. I do not know how much it is. The difficulty with directors' and officers' liability insurance claims is that no one wants to talk about them and there is no obligation to declare. The only information you get is what is in the paper, or you talk with the market and try to find out what they have paid. With the D&O claims I have been involved in, yes, I do know how much was paid, both from a damages and expense point of view, but I would not be at liberty to discuss anything with which I have had a personal involvement.
The Chairman: Do you know of any case where the courts have awarded damages that exceeded the maximum amount on the policy and in which the directors were actually stuck for that excess amount over the coverage?
Mr. Malcolm: I am not aware of such.
Senator Angus: In Canada?
Mr. Malcolm: Not in Canada. In the United States, yes.
Senator Stewart: This has been most interesting, and we are indebted to the witness.
Let us say that a person is invited to become a director of a company, and he or she is not very well informed in this area of insurance against liabilities. How could that person correct the absence? Is there some source of reliable information to which he or she could turn to discover what risks would be covered, what risks would not be covered, and whether, in the case of risks covered, the coverage was adequate?
Mr. Malcolm: I have quite a selection of books on this subject, including this one from Stikeman, Elliott. This is a book published in Vancouver by a special technical publisher. It is a very detailed discussion.
Senator Stewart: What is the title?
Mr. Malcolm: Directors' Liability in Canada.
Senator Stewart: What date is that?
Mr. Malcolm: This came out a few years ago. It is quite good. It covers all forms. It covers provincial legislation as well.
Senator Angus: It will have to be rewritten after our report.
Mr. Malcolm: Inside Press has put out a lot of information on directors' liability. I brought one of their publications along. Canadian Institute Publications has produced many publications.
The Chairman: Do you mean the Canadian Institute of Actuaries or Accountants?
Mr. Malcolm: CICA has done a whole series on directors' liability.
The Chairman: You mentioned the Canadian Institute, and there are two.
Mr. Malcolm: This is Canadian Institute Publications. The Practice in Law Institute in the States has published many works on D&O. I brought along a selection of The Boardroom. They often write about D&O. Directors' Monthly often writes about D&O, as do many other publications.
Senator Stewart: It must be a subject on which there is some uncertainty.
Mr. Malcolm: I have a handbook, that resulted from one of the working studies in Lloyd's. It gives some history on D&O, and it gives some outlines of directors' responsibilities in different countries, such as Germany, France, and so on. It gives copies of wordings. It is dated, but it has good background on the 1933 act and the 1934 act in the States. There is a tremendous amount of information on the subject, including this book from Stikeman, Elliott: Les dirigeants: leurs droits et leurs obligations.
Senator Angus: We have an English version.
Mr. Malcolm: I was only given a French version.
Senator Angus: I brought an interesting article to add to your collection of newspaper clippings from Lloyd's which, as you know, has a supplement twice a week called Insurance Day. I was quite intrigued by it, and I would be interested in your comment.
In the U.K., there has recently been legislation to give relief to corporate directors from being taxed on the directors' and officers' insurance they get. Apparently, under the U.K. tax laws, it was a deemed benefit to directors, a taxable benefit. It was another disincentive to be a corporate director.
The Chairman: Are you saying that if you were sued successfully as a director, and if the insurance company paid your claim, then that income was deemed taxable to you?
Senator Angus: No. It was the premium for the insurance. If you were on the board of a company, you may have received $100 as a directors' fee, but if they provided D&O insurance as well, that was prorated down and was a taxable benefit.
Mr. Malcolm: I personally always recommend that a director contribute towards the directors' and officers' insurance policy for two reasons.
Senator Angus: That he contribute his own cash to paying the premiums?
Mr. Malcolm: Yes. I do that in order to validate an insurance policy. In theory, since it would be a direct contract, you would need a consideration from the insured to the insurer. As well, there has arisen this question of whether the premium is a taxable benefit. Furthermore, if the corporation incurs defence costs, do they become a taxable benefit in the hands of the director? There is a very good article in this publication from Canadian Institute Publications. It is by one of the leading tax attorneys in Canada. It concerns a letter that was written by the Minister of Finance to one of the insurance companies. It was a very on-the-fence letter about directors' liability when it comes to taxes.
That letter states, in part:
I understand that the practice of Revenue Canada, Taxation is generally not to assess a director for indemnification received as a result of acting as a director in respect of a civil, criminal or administrative action or proceeding where the director acted honestly and in good faith with a view to the best interests of the corporation and had reasonable grounds for believing that his or her conduct was lawful. On the other hand, where a director of a corporation receives indemnification from the corporation even though these conditions are not met, Revenue Canada, Taxation may consider assessing the indemnification as a benefit in respect of the director's office.
Senator Stewart: By whom was that letter written?
Mr. Malcolm: The Minister of Finance on February 19, 1992.
The Chairman: Thank you very much for appearing this morning, Mr. Malcolm. As you can tell, we have greatly appreciated your contribution.
The committee adjourned.
Ottawa, Tuesday, April 30, 1996
[English]
The Standing Senate Committee on Banking, Trade and Commerce, to which was referred Bill C-15, to amend, enact and repeal certain laws relating to financial institutions, met this day at 6:00 p.m. to give consideration to the bill.
Senator Michael Kirby (Chairman) in the Chair.
The Chairman: We are here tonight in consideration of Bill C-15, known to most of us as Bill C-100, an act to amend, enact and repeal certain laws relating to financial institutions. Translated loosely, this is the bill emanating from the white paper which came out February one year ago, which in turn was at least in part spawned by the Standing Senate Committee on Banking, Trade and Commerce's committee report on financial institutions, particularly the set of hearings we held following the collapse of Confederation Life.
Our witnesses are from three different institutions. Although there are four witnesses, one of them happens to cover two different institutions, which shows a great degree of flexibility. Mr. Nick Le Pan used to be an ADM in the Department of Finance and is now a superintendent at OSFI. We also have Charles Freedman, Deputy Governor of the Bank of Canada; Mr. Douglas R. Wyatt, General Counsel, Department of Finance; and John Thompson, the Deputy Superintendent from the Superintendent's Office. Thank you very much for appearing here today, gentlemen.
As I understand, you have distributed an opening statement. Please proceed with your opening statement, Mr. Le Pan. From some of the issues discussed informally by the senators, we have a number of issues that we should like to raise with you.
Mr. Nick Le Pan, Assistant Superintendent, Policy Sector, Office of the Superintendent of Financial Institutions: Let me say how pleased I am to be here for your consideration of Bill C-15. I should like to go over the main features of the bill and comment on some selected elements.
There were four major underlying principles in the bill coming out of the white paper to which the chairman has referred: First, that the Canadian financial system must remain safe and sound; second, ownership of a financial institution is a privilege, not a right, which means the protection of the interests of policy holders, depositors and creditors comes before the interests of shareholders; third, that early intervention and resolution of institutions experiencing financial difficulty should occur; and, fourth, that there should be sufficient regulatory incentives for institutions to solve their own problems in a timely manner.
The bill draws very heavily on this committee's report of November 1994 entitled, "Regulation and Consumer Protection, Striking a Balance". I should like to go through some of the major parts of the bill that reflect the committee's recommendations.
First, it was recommended that risk-based premiums be introduced. CDIC's authority to levy such premiums is contained in this bill. I gather that CompCorp, the compensation corporation for the life insurance industry, will be considering similar measures.
Second, the committee recommended that OSFI be given the power to engage in early intervention, including the power to close an institution when capital is still positive. A legislative mandate for OSFI incorporating early intervention is conatined in this bill, as are changes to the Winding-up Act and the FI statutes to allow earlier closure if appropriate, including when capital is positive.
As part of the white paper, the published "Guide to Intervention for Federal Financial Institutions" sets out the broad operating procedures for institutions in financial difficulties, embodying early intervention principles. OSFI is incorporating that more and more into its day-to-day procedures in how it looks at institutions.
The committee recommended that CDIC, as part of the so-called FIRP, Financial Institutions Restructuring Process, be given the direct power to take control of assets of a troubled institution. That is included in this bill.
The committee recommended that "going-concern solutions" or rehabilitation processes for insurance companies be possible. This bill makes changes to the Winding-up Act to facilitate restructuring of insurance companies in order to preserve value for policyholders and potentially for other creditors. These proposals go some way to meeting the committees' recommendation. However, we looked at this in great detail and came to the conclusion that practical reality precluded what I would call full-scale rehabilitation of insolvent or almost insolvent companies back to a healthy state under federal law. We have gone some way in this bill, but not all the way.
The committee recommended that the government create a policyholder protection fund with independent directors, sharing of information with the regulator, and a mandate to participate in early intervention solutions. The bill includes a provision to share information with CompCorp, and OSFI is well along with discussions with CompCorp on how OSFI will interact with CompCorp in problem company situations.
The government did originally propose a legislated policy holder protection board modeled on the provisions in the Senate committee's report. However, the industry ultimately convinced the government that the industry could meet the objectives of the Senate committee report through changes to the mandate, corporate governance, and operations of CompCorp. Those are in place, including an independent board and a mandate that permits early intervention. In light of those developments, the government withdrew the formal legislative proposal.
The committee recommended that there needed to be more disclosure. Data needed for expert intermediaries, so-called in the Senate committee's report, to make intelligent judgments about the wellbeing of a financial institution should be released promptly. At the request of the government, OSFI has led a process to achieve this in consultation with the analyst community, the rating agency community, and with financial institutions. The enhanced disclosure process will occur in part through greater release of data that OSFI now collects through regulatory reports and in part through new requirements on financial institutions themselves to put more in their financial statements and to make statements available upon request where they are not now required to do so, including situations where institutions are not object to securities law requirements.
The committee recommended that use of the essentially same name for holdings companies of FIs no longer be permitted. This is contained in this bill, with appropriate grandfathering.
The committee recommended that a majority of directors of an FI be independent of the directors of the financial institution's holding company. The affiliated director rules are being altered so that directors of holding companies of financial institutions will be considered affiliated with the institution and therefore do not count for purposes of the institution meeting the independent affiliated director rules. This will be implemented through changes in regulations and does not require a change in the statute.
I could go on. The influence of this committee on this piece of legislation has been very significant, and I and my colleagues and ministers value your judgment and input very much. I thank you for it.
There are a few other changes that came about subsequent to the release of the white paper that are also important. For example, changes in the bill permit constraints on preferred shares being issued by mutual insurance companies. That will enhance their capability to raise capital through this kind of security without causing corporate governance problems that would otherwise arise.
Changes also ensure that CDIC coverage is limited to five-year instruments, as was originally intended.
There were some recommendations that were not accepted or were implemented in a somewhat different fashion. I will not go into all of those, but I will mention a few. There may be others that you wish to explore in the questioning. Two deserve mention.
First, the committee recommended the possibility of requiring institutions to have a certain amount of subordinated debt capital as an added way to impose discipline. We did look at this at some length, but we concluded it would not be practical for a number of companies and could be expensive given the small depth of these markets, particularly for smaller institutions.
Second, I wish to mention the issue of the appointed actuary and the independence of that position from the position of the chief financial officer. The committee recommended that one person not be allowed to hold both positions. The committee did not make recommendations with respect to other positions in a company. The bill does implement this restriction with respect to the position of appointed actuary vis-à-vis other executive positions such as the CEO of the company, the chief operating officer and people performing the like functions.
In the case of the appointed actuary, chief financial officer, CFO relationship, the bill is based on the principle that while there is a potential for conflict, there are cases where one person occupying both positions was legitimate. For example, small companies may have one person doing both roles until they grow large enough to justify two individuals full time. Movement of appointed actuary personnel can lead to the need for transition as new people learn the ropes, and that can go on for some period of time. There may also be a few cases where the audit committees of the board of directors are comfortable that sufficient checks and balances exist to permit the two functions to be performed by one person.
Accordingly, the bill does not contain an outright prohibition. Rather, it provides that, where the audit committee attests in writing that the duties of both positions will be adequately performed and the actuarial duties will be performed in an independent manner, and where the superintendent approves, the two positions can be held by one person.
OSFI intends to exercise its approval authority very sparingly. We face a situation where there are some legitimate cases and some cases where it is worrisome and should not be allowed. In this situation, I believe that the approach that we have in the bill is the best in order to achieve a balance between legitimate cases and the potential for conflict.
I am well aware of the committee's interest in this matter, and I suggest that OSFI keep a record of approvals and disapprovals under this provision. I do not necessarily mean specifically by name, but by reasons and so forth, so that OSFI could share that experience with this committee if it so wished at a future date. That would permit review of how the new provision is working and whether any further change is desirable.
I also want to make a comment about the new system of closing a financial institution. Under the current legislation, the minister is required to form an opinion about the financial condition or solvency of a institution before he directs the superintendent to take control of that institution. He does so only after receiving the superintendent's report on financial condition and his recommendation and after providing a right of representation of the institution. Clearly the report of the superintendent is essential to this process.
Under Bill C-15, the superintendent, as regulator, will be responsible for reaching an opinion about the financial condition of an institution and whether it warrants applying to a court for its winding up. The superintendent is required to provide institutions with a right of representation. It is intended that the determination of the superintendent regarding the financial condition and solvency of a institution would be as definitive as the determination of the minister under the existing regime on those matters. The focus of the minister in this process will be shifted to the broader question of public interest.
I also want to make one comment about the restructuring provisions in the Winding Up Act for insurance companies. Some of those changes are intended to simplify or clarify provisions in the existing law. Thus, the fact that a provision is changed should not by itself be taken as an intention to alter the substance of an existing law in all cases. As well, the bill makes clear that the changes in legislation in this area apply prospectively. I want to spend a few minutes on the Payment, Clearing and Settlement Act, which is implemented by the proposals in Bill C-15.
The preamble to this act describes the important purposes of this legislation and the key role of the Bank of Canada in supporting the efficiency and stability of the financial system. This act applies to payment clearing and settlement systems that are capable of causing systemic risk -- that is, the risk that the failure of one institution can cause failure of the clearing system or payment or other institutions. Prevention of this requires that the systems be adequately risk-proofed and that an authority -- in this case, the Bank of Canada -- exercise an appropriate oversight role. That is the first goal of the clearing and settlement provisions in the Payment Clearing and Settlement Act.
The second goal is to make necessary alterations in the legislative powers of the Bank of Canada so that the so-called "large value transfer system" can be implemented. This system will provide final and irrevocable same-day settlement for large payments. Canada is the only G-10 country without such a system.
Third, the act provides a statutory basis to permit netting of offsetting transactions. This is important to maintain the competitiveness of our institutions and markets.
The federal-provincial jurisdictional issue around these provisions was debated publicly. As you know, billions and billions of dollars flow through these systems daily. The reality is that if there is a failure of a financial institution either here in Canada or abroad that threatens the stability of "the system", the central banks, including the Bank of Canada, are the lenders of last resort. They will be called on to manage the situation. That is why they should have oversight over the control of systemic risk.
I want to emphasize that this part of the bill does not deal with the wider range of issues of the competitiveness of the retail payment system, access to that system or governance of the payment system. These may well be issues, and they have been raised recently in submissions to the government on the broader exercise of the 1997 review. The government is considering these issues seriously. This bill, however, focuses more on ensuring that the right tools exist to deal with systemic risk in the systems themselves.
I would be pleased to answer any questions the committee may have on any matter raised in my opening statement or in the bill.
Senator Angus: You ran through a list of some of the recommendations that this committee made in its report entitled "Striking a Balance". You could have read another list of recommendations that were not either adopted in the white paper or carried on into Bill C-15.
Mr. Le Pan, would it be your view that the balance is not disturbed with the final result, or would you agree with me that it has been tipped or that it has gone askew?
Mr. Le Pan: Tipped in what sense?
Senator Angus: The committee put forward an integrated set of proposals that indicated a philosophy of this balance between the protection of consumers on the one hand and the regulatory thrust on the other hand. When you get an integrated set of proposals and take a few away and add a few, you are tinkering with the system.
Mr. Le Pan: In the broadest sense, the kind of balance you refer to remains in this bill. I hesitate to comment on all the intentions of the report, but as I read the report, there was the balance to which you are referring. Some of the elements that I thought were key -- for example, you mention consumers -- was a better CompCorp. That is here. Another was better disclosure, and that is here. With respect to safety and soundness from the protection point of view, the vast majority of that is contained in the bill.
The biggest area that the government in its white paper did not open up was the whole area of deposit and co-insurance. Whether the presence or absence of that adds to or subtracts from the balance, I do not know. My view is that a number of key elements of that balance are there in terms of protection for the system, protection for consumers, more information, and a more consumer-friendly situation.
I am happy to talk about the broader issues of co-insurance and how the government came out, but I would not be convinced that the failure to deal with co-insurance by itself means that this balance is irreparably tilted one way or the other. The committee's report made it clear that if you were to go with co-insurance, for example, you had to have broader disclosure. I think you must have broader disclosure anyway because even without co-insurance, people can take losses in one form or another. A number of things in the system mean that people end up with possible potential losses, even if it is just lost interest from time to time.
In a fundamental sense, I am not sure that the balance is irreparably removed.
Senator Angus: That is helpful.
In your opening comments, you thanked us for our report and said it was helpful. It would not be fair if I did not reciprocate and say that much of what was in our report was strongly influenced by your learned presentations to us, both in camera and on the record.
I was a new member of the committee at that time. I was impressed with the depth and the persuasive nature of your presentations, particularly on stacking and co-insurance. You suggested that it was time to demonstrate, even if it was just putting our feet in the water, that when co-insurance was brought in at a particular time in our history to meet a particular situation, it may have been justifiable. However, in the intervening period, your words were that no viable rationale for co-insurance was stipulated and spelled out. We indicated a need for that in our report. It must be articulated. We made a stab at it, but we were hoping in the white paper that we would see more. It is in that area that I am troubled by the government's lack of courage to go that extra mile and do it.
Mr. Le Pan: I hear you. If it is any consolation, the reality is that not too many jurisdictions have started with some form of full guarantee and altered it to move to some form of partial guarantee. It is a very difficult thing to do.
Senator Angus: Once you are in, you are in.
Mr. Le Pan: That is pretty much the international experience. Some have started with less and ended with less than a 100 per cent guarantee.
The arguments pro and con are there. It is difficult to analytically evaluate the arguments without actually doing the experiment. It is hard to do the experiment without putting a lot of people through what one of the opponents of co-insurance says is a bad thing to do. If you do that, it is hard to reverse. It is hard to get the sense of comfort that proponents of co-insurance would like to have and the sense of comfort that opponents might find comfortable too if one were to move away from a full guarantee.
The last aspect on co-insurance and deposit insurance is the issue of how they relate to the protection offered for competing instruments, not all of which are within the ambit of the federal government's rules. It is an important issue as well. That may be a trickier issue than people have thought about historically. You might have all kinds of guarantees floating around out there, implicit and explicit, to provincial institutions, foreign institutions, and so on.
Senator Angus: I agree with you.
We have probably said enough on co-insurance; we do not want to beat it to death at this stage because it is not in the bill, but I want to ask you for a comment on this. During the subsequent debate on the issue, after our report came out -- that is, to the extent there was one -- I formed the view that it would be better and easier to abolish deposit insurance altogether than to have this Mickey Mouse kind of deductible or whatever franchise that we were tinkering around with. Was I on the right wicket in your experienced view?
Mr. Le Pan: I hesitate to offer you a recommendation in that regard, if you are a proponent of some form of co-insurance. I have sat through, and participated in, a number of conferences, in which the debate has basically come down to "how do you move from here to there" amongst the proponents. There are as many suggestions as there are views for how public policy should move forward on a particular issue. It is hard to offer a definitive plan. It depends on so many things, in order to get to the right approach to some form of co-insurance. There is not much evidence that you can study to talk about those kinds of implementation issues and the merits of one form or another. Ultimately, that must be a political judgment call.
Senator Angus: As long as it is, I guess there will not be any change.
Towards the end of your comments, you touched on the role of the minister in closing down an institution. Perhaps the easiest way for me to approach it is to ask you to elaborate. You said that the minister will be responsible under Bill C-15 for basically the broad, general, public concerns. Could you develop that a bit? Your agency -- however you refer to OSFI -- is still accountable to the government in a variety of ways. It is the government that will take the heat. You fellows will be doing your job. You will be exercising these new powers that are being properly given to you in this bill. Maybe you should be getting more, but we have made some steps forward. They will be taking the heat and there will be questions about why did you do this or that. I worry about divorcing the minister from it.
Mr. Le Pan: First, the minister is not totally divorced. What you have in Bill C-15 is more a recognition of relative roles. The superintendent's comparative advantage is making judgements about solvency and financial condition. The minister's relative role -- ultimately more important role -- is related to public interest. The way it is set up, the superintendent makes a judgment about solvency, but the minister has the possibility of vetoing any action on public interest grounds. I do not think that the minister is totally divorced from the situation.
However, when we are talking about early intervention, if we have arrived at that point, it is almost all over but the shouting. There may be people or institutions who feel that they have not received the treatment that they think they should have. It is back to ownership being a privilege, not a right, but ultimately people are accountable in the court system. They are accountable here to judicial review, for example. There is some experience with that. That is true with ministers and superintendents.
It is more a splitting of relative roles than it is a total divorce of the minister from the process. Ultimately, if I may be very frank, part of the genesis of this is the notion, which is in the current law, that the minister must come to the identical judgment as the superintendent about financial condition before he authorizes the superintendent to take control. That essentially puts the minister in a position where he potentially should be going through the same amount and the same degree of study as the superintendent. Quite frankly, that is not fair to ministers. I have watched them have to deal with the representation process, and so on. I think a relative split of competencies in this situation is consistent with a number of regulatory statutes, and makes a lot of sense.
Senator Angus: That is interesting. It is a fundamental part of the operation of government. Many statutes say "only the minister can, upon advice of", or, "the minister shall". I quite like the approach that you are taking, and I buy into what you have just said.
Before we leave this area, let us have a practical example. Could your superintendent today, based on doing the work, using the powers that are there, decide, "I really think we must close down the Bank of Le Pan. We must close it down tonight. We have no time. Better call the minister"? How would it actually work?
Mr. Le Pan: Let me start with how it works now. Now the superintendent acts only after a long process -- and we are making part of the process more transparent with the guide to intervention, and so on. We have already been through a significant process with the institution.
The Chairman: Yes, the guide to intervention being what we call the ladder, for the purposes of the record and sticking with our terminology.
Mr. Le Pan: One has already been through a significant process that may have lasted many months or more, even years, depending on the speed with which the institution got into a problem, and the nature of the problems that have been identified.
Senator Angus: Yes, with regular briefings to the minister in the current set-up, but in the new one you would not be talking.
Mr. Le Pan: I am not sure about that, because at the end the minister still must make a judgement. It is a two-key system. There is no totally independent ability for the superintendent to wander off by himself to winding-up court and just do it in the dead of night, all of a sudden, on a whim. There is a two-key system still. The nature of the responsibilities of the players with the two keys differs from what they have now, but there still is a two-key system. I just do not agree with the notion that the superintendent would walk in, absent absolute surprise generated by an international event or something, without there having been a pattern of briefing, or a sufficient information flow to the minister for him to exercise his responsibilities under this legislation. It should not happen any more than it does in the existing regime. The superintendent is accountable to the minister for those kinds of relationships. To do that would expose minister to a potential subsequent legal problem, just as it would under the current situation if the minister had not been adequately briefed. You would still see a pattern of briefings, a pattern of memoranda going to a minister, an adequate memorandum going to the minister, a full memorandum of the history of the situation, to allow the minister to decide whether or not to exercise his public interest veto.
I dispute the scenario you painted regarding the Bank of Le Pan and one phone call in the middle of the night.
Senator Angus: It would probably be more effective.
Mr. Le Pan: There is a tradeoff here. I am quite comfortable with these provisions. There was a great deal of time spent on these provisions, and a lot of time spent on them subsequent to the release of the white paper -- because they were fully detailed in the white paper -- with the financial and legal community. People have been involved on both sides, representing institutions, creditors, and so on. The notion of the change in relative roles was never really something that anyone got particularly worried about. There is still a reasonable balance between the need for early and appropriate action with the safety valves in my two-key system as I have described.
Senator Kelleher: I welcome you during this delightful dinner hour.
As a follow up to Senator Angus' question, I wish to make it perfectly clear that I was in full accord with the recommendations of this committee. I want to make sure whether or not our recommendations, which you are carrying out, are clear. As a lawyer -- and this is why I got a little concerned -- it was hard for me to follow whether or not the language in the statute conforms and agrees with what we thought we wanted. I sat down last week and, believe it or not, I read the notes that we were given. I became concerned over the fact that there did not appear to me to be anywhere what I call an appeal process. I asked Mr. Goldstein, our researcher, to look into this for me because I saw it as a monumental task to get out all the documents and try to go through them. He prepared a paper for us focusing on this area. I believe you have received a copy of it and you are aware of the questions I want to ask, which is fine. It is better that way. The concern I have -- and do not be sensitive about this and think I am directing it against OFSI; it is always a concern I have had with government here from drawing on my own experiences -- is that somewhere, somehow, the taxpayer, the owner, whatever, must have some right of recourse to that which we could call an arbitrary action of a civil servant. I am concerned that, according to the note I received here, the appeal provisions have been removed. I am concerned as to what recourse is left. We have taken the minister out of this play. Thinking back to my days as minister in that regard, I should like to suggest to you that I should like to see something there that, at the very least, would require OFSI to advise his minister.
Senator Angus: Why OFSI?
Senator Kelleher: OFSI is doing it. I understand what you are saying about not wanting to bring the minister into play and making the same decision twice, but should there not be some requirement so at least the minister -- that is, the government -- knows that this action is being taken?
You say, "It would be a foolish civil servant who would do this without telling the minister", but I have seen some funny things happening. We have the Minister of Justice and the Solicitor General telling us, in the airbus case, that they knew nothing about these actions being taken by the bureaucrats. I am questioning whether or not we should have some provision in there requiring some notice at least to the minister. After all, it is the minister who is responsible to Parliament.
Second, dealing directly with the appeal issue, I am concerned that there were some provisions in there before and they appear to have been removed now.
I understand the concern of wanting to get on with it and not permitting this process to get tied up in the courts endlessly when you must get this financial mess cleaned up. I agree with you entirely, but surely we must provide somewhere some right to some extent for the owners of this institution to have someone at least review the actions that OFSI takes. I am wondering what you can suggest for me.
I will be honest with you. I just received this paper today. I do not have a remedy to suggest to you, but I should like to see something there to safeguard these interests.
Mr. Le Pan: I will comment on the two points you raised. The first is the role of the minister; the second is the appeal process.
I hear what you are saying about your experience, but this situation is a little different in that there is expressly in the statute the requirement that the superintendent needs to ensure that the minister will not exercise his public interest veto before the superintendent wanders off to get an application for a winding-up court. I do not think the minister is totally out of the loop from a legislative perspective.
Senator Kelleher: But that is for a winding-up court. You are correct. That may take care of it for that situation.
Mr. Le Pan: But there are other situations in which the minister must still be involved, but on a public interest basis, for example, with compliance orders.
Senator Kelleher: But it is a negative, not a positive. You can go ahead and do it, unless the minister advises the superintendent that it is not in the public interest to do so. If I had my druthers, I would rather put a positive spin on it and say that you are required to advise him.
Mr. Le Pan: The fact that the minister has the right to exercise that veto means that OSFI must advise him. The issue of advice is separate from the issue of a minister's involvement. If the minister has a formal involvement, I do not see how the superintendent cannot advise him. Indeed, we would expect -- and, I would expect this also -- him to do so.
There have been discussions between staff of the department and staff of OSFI about a protocol concerning exactly how this will work. It was similar to what I described to Senator Angus. They would still get an MMO, and so forth. He will still get the advice, and so on, in order to make the decision.
Senator Kelleher: I am always happier to have it the other way around, namely, to put an obligation on you to report. It is just a fear that I have. You have my argument on that point.
Second, what about the fact that we have removed any appeal process here? What recourse do I have, as the CEO of bank Le Pan, if I think my brother Le Pan has screwed me? To whom do I have recourse?
Mr. Le Pan: I do not think we have totally removed the appeal process. It is important, as you say, that there be the possibility for recourse for someone who thinks they have been treated badly by the whole process.
The existing system contains, first, a right of representation. There remains a right of representation to the superintendent related to his determination.
Senator Kelleher: Is that in the act itself now?
Mr. Le Pan: Yes it is.
Senator Kelleher: That has not been removed. Therefore, I can make representation to you?
Mr. Le Pan: Yes, you can. That is done first.
Senator Kelleher: And what if I disagree with you?
Mr. Le Pan: Secondly, if the minister has the possibility of exercising a public interest veto on judicial grounds, in order to prevent the possibility of judicial review, a minister who is not prepared to hear something from a company will have some difficulties. Under the existing system, people have a right of representation. Exactly the former of that has been subject to a lot of ministerial discretion. A minister, as a practical matter -- that is, because of the judicial review problem if he did not do so-- will hear someone who wants to appeal to him.
Senator Kelleher: Could we stop there for a moment? I am sorry to be interrupting, but I prefer to do this as we go along.
I am aware of many instances, unfortunately, where ministers do not want to hear or listen, and they do not meet with you or see you. This is a fact of life. It does not matter which government is in power. I should like to see something more. I agree with you totally that minister would be foolish politically if he did not see someone, but we have lots of instances where ministers do not see people. They are just not available.
Mr. Le Pan: I understand that. Coming back to your original question, the real issue in my mind is: Is there an appeal process here? Ultimately, the appeal process is a judicial review of the decision of the superintendent or the minister. Before that, there is the possibility for an argument in winding-up court. Indeed, that is probably where the argument should occur, on the merits, if there is a dispute over the merits of the particular case.
The reality in financial institutions is that once someone has moved, yes, there is value that, ultimately, is irrevocably gone. The ultimate remedy is some kind of judicial review. It could go farther than that if people want to get into damages, et cetera. That is up to them. That does not differ from the existing structure.
The change to which you refer takes out the formal appeal right to the Federal Court. From our perspective, the notion that if one wants to argue merits, it should start in the winding-up court; and if one wants to argue the process, one should go for judicial review, seems to us to be an adequate set of remedies. This comes from the principle that once one has reached this stage, we are very far along. There have been a lot of other stages in advance, including a lot of transparency about how the regulatory structure works, and a lot of opportunity for people to know what they must do to get themselves onside. Ultimately, in a number of cases, this will be triggered by some kind of formal determination by the superintendent that more capital is necessary. If we ultimately want early intervention, my position is that there must be a balance between the rights of shareholders, companies, whatever, and the rights of policyholders and creditors generally. I do not think we have totally removed the process here.
Senator Kelleher: If I am being wound up, you are right. I have the right to raise that issue before the court. However, if I am being taken over, I am not being wound up.
Mr. Le Pan: Taken over by whom?
Senator Kelleher: By you, and running it. There is a difference here, as I understand it. I am not so bad that I will be wound up. I am not a bad basket case. What about the situation in which you move in on me?
Mr. Le Pan: Can you be more precise on what "move in on" means?
The Chairman: Do you mean "taken control of" but not with the intention of winding up?
Senator Kelleher: Yes, not with the intention of winding me up.
Mr. Le Pan: There are two situations in which that might be relevant. The first, which is explicitly provided for, is the taking control of assets. That is always a temporary proposition, essentially pending the process of some further consideration by the minister. That can only last for 16 days. They then must go through the consideration of whether or not the minister wants to exercise his powers, veto, and so forth. That is before you ever get to the winding-up court.
That is there in the current statute. There is not a right of appeal from that per se in a right of representation of the minister on taking control of the assets. That is there when the superintendent is of the view that, "Holy smokes, we must make sure that the assets are protected because we do not know what is happening here. Assets could be moving and money could be running. We better take control of the assets before value walks away." It is a short-term and temporary thing. It has been used very infrequently under the existing statute. I expect it will not be used very often under the new statute either.
Your "without a winding-up possibility" implies the notion that the superintendent would take over and run the institution for a significant period of time. To my knowledge, in all the time that I have been associated with this, we have not done that.
Senator Kelleher: Are we not giving you new and expanded powers?
Mr. Le Pan: There are no provisions to take over and run an institution for long periods of time contained in this bill.
We are not looking at a situation where we will be running the institution for months and months. As a practical matter, we have never done that. But some people think we should be able to do so and be able to turn it back to a healthy institution. As I said in my opening remarks, I very much doubt that that is real. Basically, when OSFI takes control, it is a precursor to a winding-up order within a matter of days.
If we are trying to push for some kind of solution other than a winding-up solution, OSFI is doing that with the strong suggestion by managements and boards of directors that they should sell, perhaps with CDIC assistance. That has been the experience.
Senator Kelleher: Why was it necessary to have the appeal provision in there and now remove it?
Mr. Le Pan: The Federal Court provision was put in as an afterthought. It was added at the end of the 1992 stuff. It was not there prior to the 1992 legislation. Our sense was that, if we are trying to get some reasonable balance between early closure and people not using a Federal Court action to frustrate a process of dealing orderly with assets, creditors, and so on, it posed a potential for frustration. The only Federal Court action that I am aware of at this point is being argued on judicial review grounds and not on questions of fact. We thought, therefore, that that would be an appropriate substitute.
Senator Kelleher: When you take something like that out -- and I confess that I do not know much about bankruptcy law -- does it in any way preclude the owners of these institutions from going to court to have the order reviewed?
Mr. Le Pan: Are you referring to reviewing the action or lack thereof on the part of the superintendent or the minister?
Senator Kelleher: Yes.
Mr. Le Pan: As I said, they can go to court.
Senator Kelleher: That is the question I am asking. When you take it out of the act, am I left with a right of review?
Mr. Le Pan: You have a right of review on the grounds that the minister or the superintendent acted capriciously or did not take account of information he should have taken account of, et cetera.
The Chairman: Mr. Wyatt, do you agree with that?
Mr. Douglas R. Wyatt, General Counsel, General Legal Services, Department of Finance: Yes. Section 18.1 of the Federal Court Act provides for judicial review of the superintendent's actions on the basis of error of law, misapprehension of the evidence, jurisdiction or procedural unfairness -- the usual grounds for review.
Senator Stewart: Is "public interest" defined in the bill; or is the meaning already established in the jurisprudence?
Mr. Le Pan: It is not defined in this bill. "Public interest" has been used in several other statutes.
Mr. Wyatt: It is not defined in this bill. There is no clear legal definition of "public interest". It is for the minister to decide the grounds on which he will intervene.
The Chairman: I am addressing this comment to Senator Stewart. I do not know of any act that defines the term "public interest", although I know of a whole lot of other acts that include the term "public interest." Do you know if it is defined elsewhere?
Senator Stewart: No, I do not believe that it is defined. When I heard that this was the ground on which the minister could veto, I thought I knew what was meant. I then began to wonder if I knew what "public interest" was, or if it is defined in the bill, or if the minister will know what it is. I suppose one minister might decide that it is one thing and another might decide it is another, in which case we have bad legislation.
Mr. Le Pan: You may have a different perception of "public interest". Presumably, there will be a reasonably consistent view of the financial condition. I am not sure that the implication that it would be decided differently by different people implies that one has bad legislation.
Senator Stewart: Let us imagine two ministers. One might say, "All right. This is very hard on so-and-so, whom I happen to know, but, sorry, it has no broad implication."
Another minister might quite conscientiously say, "Sure, this has no direct, broad implication, but it is bad that someone who has tried very hard should be dealt with by OSFI in this way. That is bad governance and, consequently, contrary to the public interest for OSFI to have done what OSFI has done."
I can make two conscientious arguments coming to those two conclusions. I am uneasy about the language.
Mr. Le Pan: As a practical matter, aside from any errors of fact or process, the institution in question is either insolvent, about to be insolvent, or very seriously under-capitalized.
In that situation, absent errors of fact or capriciousness in that determination, there will be a fairly important kind of public interest override. We are talking about institutions where the measurement situation is such that the institution may believe that it has positive capital but that capital may be eroding very rapidly.
The measurement difficulties in determining the difference between 1 per cent or 2 per cent capital and -1 per cent or -2 per cent are enough that the institution may well be technically insolvent.
Only some very serious public interest considerations could lead a minister to override the ultimate decision to close it immediately because everyone is losing more and more as each day goes by.
As a practical matter, the two key-system as described requires some broad public interest of serious import before the override is exercised, again, absent some process of capriciousness. Perhaps a minister would see that capriciousness and take it into account. He could judge that certain facts have not been considered. However, leaving those situations aside, the process is appropriate.
If we are truly concerned about protecting depositors and policyholders in institutions which are almost insolvent, then some broad, serious public interest must be at stake. The public interest must be more broad than a vague notion of dislike for some particular action by the institution. The public interest requirement is inherent now in the relationships between the superintendent and the minister, given their respective powers and responsibilities under the statute. That requirement will still be there. That check and balance does exit.
With that check and balance system, some pretty important public interest must arise before anything gets vetoed. Potentially, the minister may need to bring some money to the table, for all I know, to solve the problem on the government's part before the veto can be exercised.
That reflects the seriousness of the situation. We want to close things down and also provide incentives to catch these things early. That is half the point. More than closing for the sake of closing, we want to provide incentives for people to avoid being in the position and to try to inject capital before reaching that stage.
If we want to create protection for policyholders, depositors and other creditors, that is, de facto, the kind of public interest concerns which must be addressed here. That is not a problem. That level of seriousness is required because the minister must justify keeping the institution open if he exercises his public interest veto while the superintendent is saying that, on his best judgment and assuming all the facts are correct, the institution in question is close to becoming, or is, insolvent. Meanwhile, people are out there transacting with it. What are the moral hazard problems? Ministers and superintendents must realize the required level seriousness before they override the closure.
Senator Stewart: You raise the possibility that the minister may have to find some money to support his concern for the public interest. Is there any provision for reporting to Parliament?
Mr. Le Pan: Yes, in the Financial Administration Act.
Senator Stewart: But on this point?
Mr. Le Pan: On a veto?
Senator Stewart: Yes. Does he have to report or notify the people to whom he will go to make good on his implied financial commitment?
Mr. Le Pan: He cannot make a guarantee unless he comes to Parliament. He cannot do those sorts of things.
I am on public record in this committee about the minister being asked for a bridge loan in the context of the Confederation Life situation; they turned it down. That option has been investigated from time to time. Ultimately, you must have a parliamentary appropriation.
Senator Stewart: Are you saying that, in the situation where the minister feels that he should exercise a veto in the public interest and where this would entail money, he must go to Parliament before he can exercise his veto?
Mr. Le Pan: He ultimately must come to Parliament to advise.
Senator Stewart: Yes, ultimately. However, you have been good at giving us sequences, so I am asking you about this sequence.
Mr. Le Pan: That depends on the circumstances. In the case of the Bank of British Columbia, it was necessary to come to Parliament on 24 hours' notice to deal with some issues of preferred creditors and other matters. An emergency piece of legislation was put through.
In some circumstances, a institution may be technically insolvent or close to insolvency; yet for some reason or other, a broad public interest says that we should not protect depositors and creditors. You can imagine that ministers would seek appropriation authority on a short-term, interim basis. It is not possible to make a rule in advance about this.
There is precedent for various kinds of relationships with ministers and Parliament when money must be put into a situation. There have not been many of those. It is hard to know exactly how it would be handled, but it is possible the minister could come contemporaneously for some kind of authority or some notice of authority.
That situation would be no different under this legislation than it is under the current legislation. That is an important point. Ministers always get to make those kinds of decisions if they are asked. This bill does not really change that situation.
Senator Kelleher: The present act gives the right to have an appeal. That is easier than going to court to ask for a judicial review. There is a much heavier onus on an applicant asking for a judicial review than there is when a direct right of appeal lies within the statute itself. At least, that is my understanding of the law. It certainly is not learned. Asking for a judicial review is not easy; yet that is being forced on the person in this circumstance. Under the existing legislation, he has a right of appeal. Is that not correct?
Mr. Le Pan: We are back to my balance point again. Here, an institution has gone through a set of stages. There has been, for example, a formal notification of inadequate capital pursuant to the statute with a time period for redress.
In all likelihood, there was failure to redress and, potentially, some extensions at the request of applicants. That is what normally happens.
We are really at the end of the process. If there is some serious area of fact or process, a person will not have much difficulty starting a judicial review process.
Experience suggests that, in some situations, people do not want to act or cannot act yet do not want to give up. At some point, we must bring it to a close for the broader interest. These people are operating at 25-to-1 or 50-to-1 leverage ratios.
Senator Kelleher: I do not disagree with you. You must have some reason for removing it; I suppose that is it.
Mr. Le Pan: We did not want a federal court application to frustrate the winding-up process when it was appropriate, that is correct. However, I would not agree with your characterization that all appeal rights are removed. There is a right of judicial process. If, for some reason, the process is not adequately done, the mechanism is there to address that and it will be used.
Senator Kelleher: The appeal rights, to some extent, are diminished.
Mr. Le Pan: I agree.
Senator Stewart: On page 2 of your statement, you refer to "expert intermediaries, the analyst and rating community". Which clause in the bill are we dealing with there?
Mr. Le Pan: Some of the disclosure matters did not require change in legislation in order to become effective. Some of that merely required further release of regulatory information that OSFI now collects. There is no clause in the bill that relates to that.
There are some clauses in the bill related to regulation-making authority for certain information that the institutions themselves will be required to publish, as well as a requirement for institutions which do not now have annual statements available to make them available on request. I will get a reference for you in a moment to that part in the bill.
Senator Stewart: I read a story emanating from Washington concerning the relationship of some of these rating agencies and the institutions they rate. Are you familiar with the problem that has arisen and became public approximately two months ago, namely, that some of the rating agencies are asked to rate? In that case, the rating agency is likely to give the financial institution a pretty good rating. Are you familiar with that?
Mr. Le Pan: I am aware of the issue. I am not sure I am directly aware of your U.S. example two months ago, but I am aware of the general issue.
Senator Stewart: I understand that it has heated up in the United States. I wonder if it has heated up here. I noticed this story because it related to the apparent sudden change in the rating in the case of Confederation Life.
Senator Perrault: That was dramatic.
Senator Stewart: There was a dramatic change almost overnight. Is anything contemplated to ensure that these rating agencies, on which some people rely heavily, are indeed reliable? Are there too close relationships in some cases between the raters and the rated?
Mr. Le Pan: I return to my opening statement. My comment about the rating agencies and the expert intermediaries and the analyst community was basically to say that OSFI had spent considerable time talking to them about the kinds of information they now get from institutions, what institutions they do not get that kind of information from -- I do not mean necessarily specific ones, but there are groups of them -- and what other information might be useful. That was the comment in the opening statement. OSFI involved them in a process of consultation in developing the enhanced disclosure proposals.
On your broader question of the relationship between rating agencies and institutions, I am aware of the issue that you raised. The rating agencies would vehemently deny that they are not independent and worry about their own credibility in the marketplace. As well, we have situations where rating institutions rate institutions unasked, and the institutions are angry about that.
Ultimately, in the current environment, the check and balance on the rating agencies is essentially the marketplace and their credibility. The issue of who regulates the rating agencies is one that I have heard from time to time.
There are proposals floating around that the supervisor should require institutions to have a rating and that that should be formally part of a process that triggers certain actions automatically. I am not in favour of that precisely because of the kinds of issues you raise. The rating agencies will defend themselves. I do not want to come to a judgment about whether or not they are accurate in all cases.
Looking at the historical default rates, which is a matter of public record, for example, I recently saw records of default rates over 30 or 50 years on paper rated initially in various classes triple A, double A, and so forth. The original default rate on an originally triple A rated issue is minuscule. I am talking about two-tenths of one per cent over a long period of time. If you take that as a measure of accuracy of an initial rating, that is pretty good.
There may be cases where the big argument is whether some agencies move too quickly or too slowly. I expect that to be argued by various sides until the cows come home. The issue of regulating agencies gets into pretty slippery territory.
Senator Stewart: I wish to go to another topic, which is prompted by page 3 of the opening statement. You state why you do not require a separation between the appointed actuary and the chief financial officer in every case. You say that the bill provides that where the audit committee attests in writing that the duties of both positions will be adequately performed and the actuarial duties will be performed in an independent manner, and the superintendent approves, the two positions may be held by one person. What clause is that?
Mr. Le Pan: The clause related to the disclosure is clause 12 of the Bank Act, for example, and there are similar clauses for the other statutes, as well as in the OSFI act.
The reference for the audit committee is clause 76, page 62.
Senator Stewart: Yes, that is right. It is page 63.
(a) the audit committee ... has provided the Superintendent with a written statement indicating that it is satisfied that the duties of both positions in the company will be adequately performed and that the actuarial duties will be performed in an independent manner; and
(b) the appointment or holding of the position is authorized by the Superintendent.
In what circumstances would the superintendent refuse to give his or her authorization?
Mr. Le Pan: One might be in consideration of whether the audit committee adequately looked at this issue. I would like Mr. Thompson to elaborate on that, because we have been thinking about those kind of criteria.
Mr. John R. Thompson, Assistant Superintendent Operations, Office of the Superintendent of Financial Institutions: Before I do that, I should like to say that we agree with this committee's recommendation that in most cases it is appropriate that these two functions be separated.
The type of criteria that would cause us to turn down an application by an audit committee would be, as Mr. Le Pan has suggested, where we disagree with the recommendations. Perhaps the actuary or the individual involved does not have a reasonable amount of experience and credentials to be both the actuary and the CFO for the institution because doing both tasks will be demanding.
If the institution was one of those institutions that we reported to the minister on our problem company list, we would feel that this was inappropriate, and we may not have yet notified the company that they were in this particular category. In most cases, companies should know that they are reported to the minister because they are a problem company, but if we have just recently put them in that category, we may not have yet informed them of that. It is that sort of consideration that would cause us to turn down an application.
Senator Stewart: Could you look at clause 162, page 118?
Clause 162 reads:
The Payment Clearing and Settlement Act is enacted as set out in the schedule.
We then turn to the scheduling and it is entitled, "An Act respecting the regulation of system for the clearing and settlement of payment obligations".
As I understand the situation, what we have here is a complete act of Parliament -- not just an amendment but a full act of Parliament -- which is contained in a schedule to another act.
Mr. Le Pan: It is not contained in a schedule to another act but to a bill.
Senator Stewart: But the bill becomes an act as soon as it receives Royal Assent. You cannot duck my point in that way.
Mr. Le Pan: But this is a complete act as a schedule.
Senator Stewart: How many times have you done this before?
Mr. Wyatt: Actually, quite a few times. This is not something to which I had given much thought until I heard your question. For instance, the Access and Privacy Acts were both enacted as schedules. We used it quite frequently in previous omnibus bills related to the financial system. It is a matter which the legislative drafting section has adopted as a style. It could have been a part of the bill, but where it is a complete act on its own, this style has been adopted. My recollection is that the OSFI Act could have been done in this manner also, but I could be wrong on that.
As far as I know, it has not received any objections in either the House of Commons or the Senate.
Senator Stewart: Not yet, you mean.
Mr. Wyatt: If you want to make a point of order on this, notify us first.
Senator Stewart: This is not a point of order. I just think it is bad parliamentary practice, and the committee should note that. It is one thing to have an omnibus bill with amendments to a series of statutes, but surely it is a bit strange to adopt this kangaroo approach where one kangaroo is embodied in another.
Senator Angus: That would appear in the Statutes of Canada.
Senator Perrault: The committee recommended that risk-based premiums be introduced. You approve of that and it is reflected in the bill.
Have you an existent schedule of premiums which you used as a model for this system of premiums?
Mr. Le Pan: There are no risk-based premiums existing in Canada now.
Senator Perrault: Do they exist in some other jurisdictions, perhaps?
Mr. Le Pan: The United States has had a system based on the three-by-three matrix, sort of a two-fold classification. One side of that table is capital level -- that is, sort of high, medium or low, if you will -- the other is supervisory judgment based on the supervisor's ratings of assets, management, earnings, liquidity, namely, those standard factors that have been part of supervisory ratings for a long period of time. Depending on where you are, you have different premium levels.
CDIC is in the process of working on a proposal for risk-based premiums for Canada. Some illustrations were set out in the back of the white paper based in part on the U.S. system. It might well be linked to the so-called ladders that we have talked about. That is part of the various stages. There may be some other factors. The U.S. system was developed three or four years ago. They have started to look at it again. There have been no decisions to revise it, but CDIC has been talking to U.S. regulators about their experiences with their system.
There is a requirement that this be approved by the minister. It is to be a statutory instrument, so there will be a process of consultations, and so forth, on a proposal before it is finally implemented. If there is some interest here, it will be possible to come back to the committee when there is more of a proposal so that we can discuss it.
Senator Perrault: In a preliminary way, development work is being done.
Mr. Le Pan: Yes, development work is being done now in anticipation of this legislation. Capital, and other factors that I indicated, will be important in developing that system.
Senator Perrault: The ground has been well traversed here in this question process. You say in your submission that OFSI would be given power to engage in early intervention, including the power to close an institution when capital is still positive. Concerning the term "early intervention", have you established minimum criteria for this intervention, or is it just a consensus?
Mr. Le Pan: I will ask Mr. Thompson to comment on this about our process, but I wish to make a general comment here.
There is a hierarchy of actions related to people. The so-called ladders that were published at the back of the white paper do reflect a measure of reality. The idea of explicit numerical trigger points, which received a lot of favour in the U.S., was something that was looked at in developing both the white paper and this proposal, which was rejected. The U.S. system is rather different than our 14,000, now 10,000, or whatever, financial institutions on the deposit-taking side. You really need a lot more "automaticity". We opted for more flexibility rather than an automatic trigger.
I will now ask Mr. Thompson to talk about how the intervention process works in more detail.
Mr. Thompson: To begin, we must start with the so-called ladders. The process of identifying the position on that ladder that you might put any single institution depends to a great extent on judgment that is established by the superintendent in terms of the capital standard, its ability to recover if it does not in fact have good earnings power or adequate capital at the moment, the role of management, the role of the board, corporate governance issues, its access to capital markets, and a whole host of issues.
Senator Perrault: All these factors are considered, then?
Mr. Thompson: They would all come into the equation.
A very important part of a company's lot in life in this ladder is the ability to work its way out of whatever problem it has. In our "Guideline to Intervention", you will frequently find references to business plans. Those business plans are meant to be references to the plan of reconstruction that the company would be imposing on itself to remedy the financial problem that it is facing.
Obviously, as you work your way down through the various stages or the ladder, you will find yourself dealing with an institution that has tried everything at its disposal and has yet been unsuccessful in solving its financial problems. The typical situation would be to make a demand to increase the capital.
Senator Perrault: And run the litmus test?
Mr. Thompson: That would be a market litmus test, if I could word it that way, because we would have formulated our opinion that the company was in very bad financial straits.
Senator Perrault: And then the market would give its opinion.
Mr. Thompson: And then the market would give its opinion, that is correct. We would then know what we were dealing with in terms of a remedy. There would be a whole process involved before you got there that would allow us to form a good opinion of the ability of that institution to remedy its financial problems.
Senator Perrault: Mr. Le Pan, I will quote from page 2 of your presentation. We all support your statement:
That data needed for expert intermediaries to make intelligent judgment about the well-being of a financial institution be identified and released promptly...
Who are these expert intermediaries and what kind of professional expertise should they possess? It is a statement we can all support, but there is no guarantee of intelligent judgment either.
Mr. Le Pan: No, but we are talking to some extent about a bit of caveat emptor here. I think the groups included in that terminology include the rate agency community and the analyst community, by which I mean investment banks looking at institutions and publishing reports. I think in some cases it may well be people who are managing pools of money they have invested in these institutions and who are not fully covered by deposit insurance.
Senator Perrault: That sharpens the mind a bit, too.
Mr. Le Pan: It certainly does. People responsible for managing pools of funds invested, in part, in financial institutions or someone managing a group business for an employer may wonder about the claims-paying ability of the insurer who is the carrier of the group business. If you are a big employer with a large amount of group business, presumably that is part of what you should be looking at.
The intermediary concept was actually in the report of this committee. It related more to the notion of analysts.
We must recognize also that there are mechanisms by which that kind of information gets out beyond that community. Not everyone reads the business pages, but there are more people who read the business pages than are expert intermediaries under my definition.
Senator Perrault: More than 10 years ago?
Mr. Le Pan: Yes. The situation of financial institutions shows up in the business pages from time to time often in advance of when they are actually closed. In my experience over the past 10 or 15 years, there are very few pure surprises in this system.
That is the intermediary concept. However, in addition to intermediaries, people are responsible on behalf of others for managing funds, insurance and businesses, and we are providing them more information.
I also recall that a few municipalities were caught out with the closures of a couple of banks back in the mid-eighties. If you are treasurer of a significant municipality and do not want to rely on a rating agency or something else to monitor it, we will be giving you more tools to look at numbers yourself if you have significant amounts of money invested. The notion of more information is out there to protect and help a lot of people.
Senator Perrault: That is encouraging.
Senator Stewart: I have a question or two concerning the proposed act on payment, clearing and settlement. How will this work to prevent systemic dangers? There is a lot in here on getting information. However, going beyond access to information for the bank, where a systemic risk is detected, what provisions are there to prevent that risk from becoming actualized?
Mr. Charles Freedman, Deputy Governor, Bank of Canada: As you mentioned, we will start by looking at all the clearing and settlement systems. The act provides for the Bank of Canada to get information so that we will know which of those systems has the capacity to bring systemic risk to the financial system.
We do not expect that many clearing and settlement systems will have the capacity to bring systemic risk. We are really talking about a situation where the failure of a participant in the system could lead to the domino effect. It might bring down other systems.
The way we propose to go about this is to work very closely with these systems to ensure that their structure is such that the risk coming out of a failure would be contained or controlled. I will mention three systems now because we have been working most closely with them in advance of the legislation. They are, first, the large value transfer system being developed by the Canadian Payments Association, which is a payments system. The second is the Canadian depository for securities, which has a debt clearing system on which Government of Canada debt is housed. We are talking about billions of dollars going back and forth. The third is a system in the process of being developed called Multinet, which is a foreign exchange clearing settlement system. These are all very similar in the sense they are very large and large amounts of money travel back and forth.
We have gone through the following thought experiment with each system. Suppose a very large participant such as a major bank should fail. How would that impinge on the ability of that clearing and settlement system to settle?
There has been a lot of international development in this direction. These systems all have a mix of caps on the amount of exposure any particular institution could bring to the system. Bilateral lines of credit are developed between institutions, which give each institution the ability to limit the amount of risk they face vis-à-vis the system. Different institutions bring collateral to the system. All that put together has led to a situation where we feel comfortable that even if a major institution failed -- what we call the single largest net participant of the system -- the losses would not bring down other participants or systems.
To go one step further, if a system does not possess these risk containment systems to our satisfaction, the act provides the bank with the power to issue a directive to instruct the system -- in either the clearing house or, where there is no clearing house, the participant's system -- to cease and desist from bringing that kind of exposure to the system from the carrying out of activities which can result in systemic risk for the entire financial system.
Senator Stewart: Which clause is the operative clause?
Mr. Freedman: The directive is clause 6, and that directive is only for systems which have been designated. I am talking about large systems that have the potential for systemic risk.
Senator Stewart: How many person years in the bank will this statute require?
Mr. Freedman: We have a number of people working in these areas right now because we are very involved in the financial system and these kinds of clearing settlement systems. I would guess we are talking about one to two person years. The act gives us the power to charge back, and we will charge back the cost of that to those clearing and settlement systems.
Senator Stewart: That is very interesting. When it is running, it might be good to have these people back to hear how it is working.
The Chairman: That is a good point.
I have three or four questions on different topics. I will begin with the payment system question.
Mr. Freedman, is it reasonable for us to assume that because the Bank of Canada has been given an increased role in the payment system in this bill, the bill is a forerunner to the Bank of Canada being given an increased role in the payment system down the road?
Mr. Freedman: I do not think one can draw that conclusion. There is something rather special about the clearing and settlement systems.
The interest of the Bank of Canada has always been in the integrity of the financial system and the ability to withstand shocks. This has become much more important over the last 10 to 15 years. I would date it more from the stock market crash of 1987 after which the president of New York Fed began alerting people to the potential risk coming out of these clearing settlement systems.
We have seen an enormous growth in the size of financial closures. The development of systems has concentrated risk in these systems.
With the enormous growth in relationships between institutions that purchase and sell, it is becoming more and more of a concern that if something does go wrong, we would have systemic risk. If people rely on certain elements of the system -- for example, netting -- to protect them from the problems they foresee, and if it turns out that the netting is not well grounded in law, there may be a risk that people were not aware of.
Over the last few years, we have had a lot of initiatives under the aegis of the G-10 governors -- that is, the group of 10 countries, many published by the Bank for International Settlements -- which have focused on these kinds of risks, both nationally and internationally. It is not only Canada that is concerned about this, but all the major countries. There are many cross-border risks. We have not been as involved over the years in what you might call the retail payment system.
The Chairman: I understand that. My question referred to the hope that you were to start moving in that direction.
Mr. Freedman: We will have to wait and see how that develops. I am not sure that I would draw that inference from this. There is something of special concern to central banks about these kinds of large clearing settlement systems.
The Chairman: If the Canadian payment system were opened up -- as there is some pressure from a number of sources to do, and as several members of this committee have observed from time to time that they would favour -- is that likely to emanate from the department or is the principal focus of that discussion likely to be the bank?
Mr. Le Pan: The payment system issues are complicated, as I know you and other members of the committee appreciate. As a result, I do not personally believe that it is possible to separate the responsibility among the department, the bank or, for that matter, OSFI.
The Chairman: I am happy to take a joint-and-several type of answer.
Mr. Le Pan: I am getting there. The issues of access to which you referred raise issues of public policy, competitiveness and so forth in the system broadly. At the same time, I do not believe that it would be desirable, if that were to be done, that it be done in a way which would enhance systemic risk. That is not to say that it cannot be done, but it is more a joint-and-several type of thing than a one-versus-the-other type of thing.
The Chairman: I think what you said was that if this committee were to decide, in its wisdom, to hold some special hearings on the payment system as a separate topic, we would want representatives of all three organizations before us and not merely one. Is that correct?
Mr. Le Pan: That is correct.
Mr. Freedman: Perhaps I could add that in the course of preparing legislation and dealing with these complex financial issues, the four agencies -- the Department of Finance, the Bank of Canada, OSFI and CDIC -- do work very closely together, in a variety of arrangements and at a variety of levels, from the most senior level, to our level, to working levels.
The Chairman: You may well be hearing from us on that.
On the issue of conditions being set for risk-based premiums, am I correct in assuming that size, in and of itself, is not likely to be a factor? There are people who have a view, which I passionately do not share, that small institutions are riskier than big ones. Am I correct that size is not a factor?
Mr. Le Pan: That is correct.
The Chairman: Why does the bill allow CDIC to borrow now from sources other than Consolidated Revenue Fund? Are you charging them too much?
Mr. Le Pan: Most Crown corporations have the authority to borrow in the marketplace. As a matter of policy, they have been encouraged to borrow in the marketplace, in part for accountability as to the real costs of their operation. CDIC is one of the few that does not even have that authority, not to mention actual practice.
In addition, the government announced at the time that the white paper came out that the government intended to charge CDIC some cost for use of the government's name, its guarantee essentially. I think those developments are more related to that broad policy. There was also an issue regarding fairness between a private sector compensation corporation which would borrow, if it borrowed, at more of a private sector rate without a government guarantee. I think that was a factor in the decision both to have CDIC borrow in the marketplace and to charge it a guarantee fee.
CDIC will continue to have access to the Consolidated Revenue Fund short-term borrowings particularly because CDIC may need to have access to significant amounts of funds on a very short-term basis to deal with a problem-financial-institution case. It might not be appropriate, in that circumstance, for them to be forced into private markets, at least for the short term. They might borrow from the CRF for the short term and then term it out in private markets subsequently.
The Chairman: I have one last question. As you know, this committee has had a long interest in information that financial institutions are required to make public. The bill leaves to regulations the details of what information financial institutions will be required to make public. I have been told somewhere along the line there are ongoing discussions between the industry and the government on those regulations. I have a two-part question. First, do you anticipate being able to achieve a consensus from all segments of the industry on what those regulations ought to be? Second, are those regulations going to be tabled with the committee when you get them finally agreed upon?
Mr. Le Pan: There are several questions there. First, as I indicated earlier, a lot of the enhanced disclosure will not happen through the regulations; it will happen through enhanced disclosure of the information OSFI already collects. That has already started as of the first quarter of this year. Some of it will happen through regulations.
Senator Angus: It has already started?
Mr. Le Pan: There is authority that exists to do that.
The Chairman: That is pursuant to the discussions that came out of our report, and then we had a long discussion with the superintendent in this forum, I believe, on exactly that issue.
Mr. Le Pan: Part of that was solved. The legal issue was solved. That all got solved in one way or another and there is more going on.
Senator Angus: Good.
Mr. Le Pan: The next part of your question was whether we could reach consensus with institutions. I think on most of this we have reached what I would call a reasonable modus vivendi. The broad outlines of what the government thought should be disclosed were set out in the annexes to the white paper. We did make some changes along the way where there were some legitimate arguments about why some things did not make a lot of sense from the institutions' point of view. I think they are reasonably happy. There are some pieces outstanding. For example, the Canadian Institute of Actuaries and the CICA are working very hard on a proposal for expanded disclosure of information in actuarial opinions, which is a big issue. There are some very detailed proposals out now which hopefully will be implemented later this year or very early next year. They may not even have to show up in regulations at this point, if we are satisfied with what the CICA and Canadian Institute of Actuaries do for their own practice. Then there will be some parts of the disclosure regime which will be included in regulations.
I think that if the committee was interested in the disclosure regime involving its various elements, any aspects that are in regulations, I would be happy to have them transmitted to the committee when they exist, but, in addition, we want to put together a broader package to describe some of the other elements which are at least as important, as I have indicated. I would be happy to arrange for that if the committee would like.
The Chairman: That is down the road, I think. I would like to get further through your process but down the road I think we would want to do that because it has been an issue of some concern to the committee for some time.
I cannot resist one last comment on Senator Stewart's issue of the public interest. I think I will circulate to all members of the committee -- and, even better, to the government lawyers, since I share the concern -- a wonderful paper written almost 20 years ago by Professor Bill Stanbury of the UBC business school, in which he details 32 different definitions of the public interest, beginning with Plato and going all the way up to the current day. The only reasonable conclusion you can draw from reading these definitions and the way they have been used is that term "public interest" can be taken to mean anything by any person under any circumstances whenever they want.
I share Senator Stewart's view that including the phrase "the public interest" in a piece of legislation generally is like giving carte blanche. I am not suggesting that we change it in the act.
Senator Angus: It is not in the public interest.
The Chairman: It certainly provides maximum flexibility to the decision maker.
Mr. Le Pan: Yes, but it is balanced by checks and balances on accountability.
The Chairman: I understand that. Some of Professor Stanbury's 2000-year-old definitions are quite applicable today.
Senator Stewart: As a footnote, Senator Allan MacEachen is retiring from the Senate after a long public career and a conference is being raised by his alma mater, the topic of which is the public good at the beginning of the third millennium -- that is, the public interest. Anyone who wants a definitive definition should arrange to attend.
The Chairman: To show you what a non-partisan event it is, it is being held at St. Francis Xavier, which we know has had some modest appeal to some members of the Conservative party.
I wish to thank the witnesses very much for their appearance.
Senators, shall we proceed with clause-by-clause study, or can we dispense with that and simply proceed with a motion to report the bill back to the Senate unamended?
Hon. Senators: Agreed.
The Chairman: I take it such a motion has been passed.
The committee adjourned.