Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 5 - Evidence - November 20 meeting
OTTAWA, Thursday, November 20, 1997
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:05 a.m. to examine the state of the financial system in Canada (institutional investors).
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, we are continuing our examination of the state of the financial system in Canada with particular emphasis on institutional investors. We have two witnesses this morning.
Our first witness is Mr. Murray Davidson, Senior Partner and Chairman of a consulting firm based in New York and Arizona called Perform Consulting.
Mr. Davidson is here to talk to us about his experience and the experience of his firm in acting as consultants and advisors on corporate governance to a number of institutional investors in both Canada and the United States and specifically to talk about his experience in the United States with senior institutional investors such as CalPERS.
Mr. Davidson will begin with a few overheads, the hard copies of which have been distributed. We will then have some questions for him.
In the first set of hearings, repeated statements were made about the good and bad role of CalPERS as an active institutional investor in the United States. Mr. Davidson was involved in developing the CalPERS guiding principles on corporate governance which are before you. He is here today not to talk uniquely about CalPERS, but to talk at the broad level first and then come down to the specific experience with some of his larger clients.
Thank you for coming over here to give us your presentation.
Mr. Murray G. Davidson, Senior Partner and Chairman, Perform Consulting: Mr. Chairman, it is a pleasure to be back in Canada. I was born and educated in Canada.
I wish to expand on the chairman's introduction to explain a little further my background in the public pension plan industry and the mutual fund industry. My firm consults extensively to those sectors of the financial services industry and I am a specialist in that area on the issue of corporate governance practices and principles to both the mutual fund industry and the public pension plan industry. I am here to speak today on the practices, on what has happened in the United States in public pension plans, why they have taken the initiatives they have, what impact those initiatives have had on the corporate sector in the United States, and what relevance they may have for Canada.
From a bit of background discussion and reading, I understand that one of the issues before this committee is the role of the institutional investment community. There are some parallels between Canada and the United States. The mutual fund and the public pension plan industries are very large, and those funds are very large. They have significant percentage share holdings in corporations. That is probably more true in Canada. Because of the size of the Canadian economy, the percentage of share holdings in Canadian corporations by public pension plans would be higher.
I will focus my comments today just on that group, where there are some parallels between Canada and the United States. I understand the line of thinking that says that because of that share of ownership in these corporations by public pension plans, there may be an opportunity for the public pension plans to use that position for whatever purposes may be on their mind. That could be done as shareholders, but the concern is that perhaps they would use that position for some other opportunities -- some quarters may say to abuse the opportunity. Without speaking for you, I think that may be an issue in your minds.
That raises the question of whether there is a need in Canada, as there is in the United States, for some degree of self-regulation by the public pension plan industry or, alternatively, for some legislative framework that may guide their actions, or perhaps even for a more formal, external type of regulation beyond self-regulation. I will speak to these issues to some extent.
In the context of the U.S. public pension fund industry, I should like to talk about why the major funds have taken the corporate governance initiatives that they have, what impact that has had, and what implication there is for Canada. If I may leave some conclusions with you, there are three messages on which I will elaborate.
First, there is a long history in the United States of activism on corporate governance by the public pension plans. There is even a history before that of activism on what I might call social issue by some of the public pension plans. That situation is changing significantly -- in fact, as we speak -- in the United States, and I will deal with that later.
However, there is a long history and there have been various strategies adopted by public pension plans as to how they would go about doing this. I will go into that in some detail. I also intend to profile two major funds, and you will be able to see the differences in the approaches they have taken.
The second message is that there is in place in the U.S. right now a legal and regulatory framework within which these funds must operate. That, too, is changing. Historically, it has been a framework at the state level. There is a significant shift in that framework to the federal level. I will go into some detail on that. However, there is a regulatory and legal framework in place and it is changing significantly.
Third, there is no question that the initiatives by the major public pension funds have created an impact in a variety of ways on corporate America. They have been a significant contributing factor to changes in corporate governance practices and procedures in major corporations in the United States. Corporations have changed the composition of their boards of directors, how they operate, how they are structured and how they relate to the shareholders and the management. There is no question -- and I think I can show you some evidence of this -- that the major public pension funds in the United States have been a significant contributor to that.
In terms of impact, there has been a significant improvement in the financial returns of the companies with which the major public pension plans have taken these initiatives. They have annual targets which are within their portfolio investments which they set down in either a more partnership-type of format or a more confrontational format and seek to bring about improvements in financial performance. There has been a significant improvement in the financial performance of the target companies, and I will show you some evidence on that.
I should like to take, perhaps, 20 minutes to go through some of this in a little more detail and then answer any questions you may have, if that is reasonable, Mr. Chairman.
The Chairman: Please proceed.
Mr. Davidson: There are copies in front of you of some of the overhead transparencies that I will be using. They may be of more advantage to others in the room other than senators.
Let us begin by looking at two of the major public pension funds in the United States. The two that I have selected are ones with which I am very familiar. One is CalPERS, the California Public Employee Retirement System; and the other is the TIAA, although for today's purposes I will call it the CREF, an acronym which needs to be changed. That represents the teachers and college professors fund in the United States. I have selected some criteria by which we might discuss those.
CalPERS is the largest public pension fund in the United States at $119 billion. It is approximately the size of the Canada Pension Plan in terms of assets invested.
The TIAA is the third largest in the United States at $89 billion. I should like to bring alive a bit of their practices and experience so that we can better understand it.
Historically, CalPERS has adopted policies and taken action of what I might call a social investment nature. They have been social activists. This is not recent history, but from 10 to 15 years ago.
To some extent, CalPERS adopted these policies because they were required to do so by California law, which required that because they were administered under California law their investments would comply with the policies and criteria established by the state, for example, not investing in certain countries, not investing in corporations that have practices or operations in those countries, not investing in corporations that did not have declared diversity policies, and so on.
By and large, CalPERS complied with the state requirements and limited its social activism to that. However, recently it adopted two approaches to introducing change in corporate governance. It is, perhaps, the most proactive of all the public pension funds.
I have distributed a copy of my summary of the draft of the CalPERS guiding principles which they issue to all the companies in which they have an investment. They have been the leader in introducing guiding principles. They not only prepare these but also sit down in discussion with the companies on a one-on-one basis and go through what they should like to see the company adopt as the principles on corporate governance.
As you can see by the broad categories there, they deal with questions such as the composition of the board, the relationship between board and management, the number of independent directors and the compensation of the board members. It is very specific.
The approach that CalPERS has taken in the past was one of sitting down and, perhaps, using more persuasion. To some extent, it is fair to say that they received dismissal by a number of corporations, perhaps neglect by others, even though they were significant shareholders. That has brought about a change in the approach by CalPERS. On this page of the handout, I have described their approach to corporate governance as being very public. That is why they are newsworthy and why probably everyone around this table has heard or read of CalPERS, namely, because their approach is not only to set these principles but also to make them very public.
The second element of CalPERS' corporate governance approach is to establish targets every year within their own portfolio, which are companies they consider to be underperforming financially. They declare those and publish them. The world can then read about them. It is probably fair to say that it is serious for a company to have less than admirable financial results. It is embarrassing for a company to have its shareholder publish information on those results for the world to see. This public approach strategy by CalPERS has been a very important element of their approach. They want to bring about change and they want the world to know that they will bring about change.
They would describe their approach as "partnering." They sit down one-on-one to try to do this. They do not seek board membership. There are declared positions by CalPERS, and most of the funds, that they are not trying to run the companies. They state publicly that they do not have the skill to run those companies. Their business is to run pension funds. They are trying to improve the practices of the companies through changes in the board of director composition, membership and practices. That is their catalyst. However, they do not try to interfere in the strategy, direction or operations of these companies.
They would say that "the kinder and gentler approach" did not work. That is my characteristic quote, not theirs.
The degree of dismissal in the early years was not acceptable to them and they have been much more aggressive. The media is full of anecdotes of their discussions with General Motors, which changed significantly the composition of that board. It could be argued that it changed the chairmanship of that board. They have become, perhaps, aggressive partners, which is a better way to put it.
TIAA is the third largest in the United States. It has a longer history of social investment policies and social activism. Even today, it is much more prominent in doing this. The difficulty they have as we speak is that they are under Internal Revenue Service review in the United States for exceeding the boundaries of what is called sole purpose requirements. The sole purpose requirement I will deal with in a minute is that their sole duty of loyalty must be to their members, and their actions must be driven and motivated by an improvement in the financial performance of the funds solely for the benefit of the members. The IRS is looking at the practices of TIAA with a view that they have stepped outside those boundaries and are risking making TIAA a taxable organization. That has serious implications for the net return to the members of that organization. That issue is before the IRS now. Considerable discussion and lobbying on that issue is occurring as we speak.
Similarly, they have principles of corporate governance but are less public with them than CalPERS. They have been active in corporate decision making and are trying even harder to get more involved. Their profile is much more openly confrontational than the approach of CalPERS, if I can contrast it that way. They are aggressive.
Perhaps it is their membership of college professors and teachers that still continues this approach of social activism. Nonetheless, they are making statements, as CalPERS does, that their primary focus is the interest of their members. They vote their proxies like CalPERS does.
I should point out that that is different from some of the practices of institutional investors here in Canada. It is my understanding from dealing with the mutual fund industry in Canada that they do not vote their proxies. This is different from the practice in the United States. They are not trying to run the company, although they may be trying to change the company.
A reasonable paraphrase of their characteristic quote is that they may crusade for social causes, but they do not want to invest on that basis.
The Chairman: Am I correct in assuming that the IRS believes that they may be investing on that basis?
Mr. Davidson: Yes, and they are doing things beyond their investment practices and policies that are causing them to move into the arena of trying to bring about corporate change well beyond their investment practices.
Something at the bottom of my brief is a matter which you may want to consider, namely, the whole indexing of their holdings. I will raise this at the end of my remarks as something that may be relevant for public pension plans in Canada, and perhaps for the CPP. There is a significant percentage of the invested assets of these funds that is indexed, by which I mean, in very general terms, that the investment takes place through another fund. Essentially, the return they receive is based on an index fund of certain industries, and they are not taking direct positions with those specific companies.
Approximately 43 per cent of the invested assets of CalPERS are in the form of indexed funds. So, yes, they are active, and they set guiding principles for corporate governance. However, a significant percentage of their shareholding is in funds through which they have no influence on the corporate governance. It may appear somewhat contradictory, but TIAA has an even greater percentage of their funds in index. That may be something on which to deliberate.
Briefly, I should like to address the question of whether or not the initiatives by these funds have had any impact. There is no question that the corporate governance practices have changed in those companies in which these funds have investments. It is a personal view that they were essentially ahead of their time in trying to bring about changes in corporate governance because many corporations in the United States and Canada have implemented changes in the structure and the practices of their board. If you were to pick up a copy of any annual report of a large corporation, you would see a statement on their corporate governance practices.
Clearly, there are other factors at play. There have been major studies in Ontario, other parts of Canada, the United States and the Cadbury study in the U.K. They have shown the way here. The corporations are getting on the bandwagon, and have done so very aggressively in the last five years. CalPERS may have been introducing something 10 years ago that was a bit ahead of its time. You will now see that there has been a lot of change in these practices, although perhaps not so finely tuned as the guiding principles that they are pointing out because that is still arguable by the corporations.
There have been changes. For example, I have seen many more independent directors on major corporations in Canada and the United States. I have a direct experience, since my consulting firm was retained by a group of independent directors of a corporation in Canada to address an issue because there was a degree of unease about the resolution of the issue by the board as a whole. The independent directors commissioned consultants to look at this and then took the results back to the overall board. That would not have happened 10 years ago.
To follow the sole purpose objective of these funds, the real test is whether or not they have had a significant financial impact. Briefly, what I have tried to represent on this page is what I have called the "pre-CalPERS campaign, 1982-87" and the "post-CalPERS campaign, 1987-92".
What I am looking at here is solely the performance of those companies which they have targeted. They publish a list of 10 targeted companies annually. I have given you a copy of the list for 1997. What we are looking at here is the improvement in the financial performance -- that is, the return to CalPERS for just those targeted companies. You can see in the pre-campaign period they were one-third of the returns of the S&P 500 index, whereas in the period afterwards they were approximately 7 per cent higher.
What is "cause" and what is "effect" here? Those are the results. There are a number of other factors at play. Nonetheless, in the view of CalPERS, something is working.
Let me spend a minute on the U.S. regulatory and legal environment. Virtually all public pension plans in the United States are administered by trust law. They are trustees. They must comply with the requirements of that law. This is sometimes forgotten, particularly with the recent public profile of these funds. I will not go into a lot of the detail, as I am not in the best position to do that. There are other people around this table who would know that better than I would. However, that is the basis for their existence.
Historically, they have been administered under state law. CalPERS would be administered by the laws of the State of California. There are specific requirements as to their membership and the responsibilities of their board that are stated in the California requirements and regulations. They must, in their view, serve as trustees.
There is a piece of federal legislation in the United States called ERISA, which is the law that relates to private pension funds. ERISA relates to private pension funds. It has very strict requirements on how they must act in regard to investment policies, composition and acting on behalf of their members. The list is extensive. It is the foundation by which the private funds are governed.
There has been a public version of ERISA aimed at the public pension funds which has been introduced in Congress. It has not been enacted. However, there is a version saying, essentially, that the motives of the public pension funds and the private pension funds are not much different. They are there to serve their members. Why should there be a different set of rules for public plans than for private plans? There is something before Congress right now in draft form for a public version of ERISA.
The most important regulatory change in the United States is the proactive approach by the Internal Revenue Service to adopt this sole purpose duty of loyalty requirement. They are starting to bring that wording into their own regulations as they relate to public pension plans to try what is called a "creeping" ERISA. That is being done so that they can ensure that, for these plans to maintain their non-tax status on their income, they have a sole purpose duty of loyalty. That is the basis on which the IRS has been having discussions with TIAA. The IRS thinks that TIAA has stepped out of bounds of those regulations.
I should like to raise several issues with you in the Canadian context. Perhaps we can discuss them more during the question and answer period.
There are major parallels in the public pension plan sector in Canada and the United States. Measured against the size of their economies, or by any measure, these plans are very large. There tends to be a large focus on these large plans. People always talk about OMERS and the teachers' plan in Ontario, but there are a lot of smaller plans.You should keep that in mind.
In the United States, that is a major issue as well. There are very news-profile plans like CalPERS, TIAA, the Wisconsin plan, the New York plan, the Florida plan, and so on. They are very active and large, but there are a number of small plans that are dutifully following their sole objective. One must be careful not to try to establish guidelines that relate to the few and not to the many.
One of the first questions I raise here is whether or not there are tax implications for public pension plans in Canada that are what I would call "governance active." Is there a comparable situation with Revenue Canada as there is for the IRS? Do they have regulations that pertain here?
Second, there is consideration -- and this may be a reality -- for some shift in what is called the 80-20 rule on RRSPs? I have discussed this with people in Canada who feel that this will change the equation for the public pension plans and the mutual fund industry -- that is, those that have any role in investing either in RRSPs or in pension plans generally. There will be some change in the 80-20 rule, thereby enabling less investment in Canadian companies and more investment in non-Canadian companies.
There is a feeling that this may change the whole equation on corporate governance, that these issues will disappear, and that the focus will shift to companies outside the country. I do not think so. These issues of corporate governance are here and they exist without the public pension plan actions in the United States. I think they will continue because they are fundamental issues on how companies operate and direct themselves. The 80-20 rule may change the formula a bit for what is invested where, but I am not sure it will dilute the interest in corporate governance by these public plans or by others.
On the Canada Pension Plan, as an outsider, my understanding is that there is some consideration in Canada of the Canada Pension Plan perhaps being unable to invest in Canadian stocks. There has been a similar legislation provision in the U.S. The U.S. equivalent of the Canada Pension Plan for citizens of the United States is now able to invest in stocks of companies. That is a change that took place in 1996. It was probably one of the most un-noted financial news stories in the United States for a fund of that size to be able to invest in corporations. There is a parallel here with Canada.
The question I would ask is whether or not the indexing potential may be a way of avoiding another version of this issue on public pension plans as it relates to the Canada Pension Plan. If the Canada Pension Plan, because of its size, were to invest in corporations in Canada, would you have the same concern or even greater concerns about potential opportunity for distortion of corporate decision-making and strategy? Maybe one of the possibilities is to enable them to invest in companies through indexing, without investing directly in companies.
Those are perhaps more thoughts for you than they are conclusions.
The Chairman: Thank you very much. We will begin with Senator Oliver because he must leave shortly.
Senator Oliver: First, I should like to thank you for the excellence of your presentation. You raised a number of issues that are fascinating in their scope and in the implications that they may have for Canada and what we can and cannot and should or should not do.
My main interest in this whole topic is on the idea of activism. We heard from people yesterday and last night who spoke about it, and you raised it not only in your presentations but also in the handouts that you distributed to us. One of the things Tom Hockin said to us last night was that there is a lot of work to be done in Canada in relation to corporate governance in their industry and they are looking to the United States to see what steps they have taken there on a number of the corporate governance issues that we are studying.
In the paper that was handed out called "Redefining Corporate Governance", a number of questions were listed that were put to some of the large funds. You analyzed how active they are and just what steps they take. I will refresh your memory and ask you to talk about the conclusions reached and where you go from there from a regulatory point of view.
Mr. Davidson: I am not the author of that paper.
Senator Oliver: That is fine. That document suggests the following:
- Writing a letter to a Board conveying the investing organization's point of view;
- Verbally conveying the organization's point of view to a Board;
- Suggesting more direct involvement by the investing organization in the oversight of the Board;
- Voting in favour of a share holder resolution; or
- Sponsoring a shareholder resolution.
In Canada, I think that people involved in those funds, and others, would say, "We do not want to be very active at all; we would like to gently suggest something." In the United States, you have gone further. What has been the effect of this? How far did the companies say they went?
Mr. Davidson: That is a good question. The practices in the United States are similar to those types of initiatives that you are outlining in that paper.
The companies have taken major steps in the United States. It is fair to say that at this point in time the public pension funds are not trying to do this to gain control of the companies or to change their course of direction. They are trying to improve their financial return. Many of the questions that you raise are questions that have been raised by the public pension funds.
I am speaking to public pension funds only and not to the mutual fund industry. They behave differently in the two countries but there are certainly parallels in the United States with the questions that you are raising concerning that paper.
Senator Oliver: Normally, they have been asked, "Well, if you are being so proactive, are you doing anything other than trying to improve shareholder value for your shareholders?"
Do you know of examples where they have in fact gone too far and where this kind of activism has done harm or damage? If so, what kind of regulation control or suggestions should we, as a committee, be looking at to ensure this that does not happen in Canada -- that is, if it is the case?
Mr. Davidson: One of the messages I should like to leave is that if we look earlier than the most recent five years in the United States, clearly, there was what I would call social activist approaches and propositions put forward by these funds. Of the two that I characterize, the TIAA is one of those funds that was very active in this area. We are not talking about governance practices, we are talking about changing society.
To some extent, that still continues -- although the regulatory and legal framework and the changes in it, which I tried to describe, are reigning in some of that to a fair extent for fear that it would cause a change in their tax status. Nonetheless, TIAA and other funds are very active in this area. They are very specific in investing in companies that have certain policies on certain social issues and not in other companies.
The approaches can be very confrontational, there is no question about that.
There are many anecdotes I could tell you today, but the discussions with General Motors are probably the classic. Essentially, there was rebuttal and dismissal by General Motors on all of the initiatives by CalPERS and others. They changed their tack and started working through a board of directors at an individual level.
Senator Oliver: In the examples you have given us, you talked about how these two organizations you have targeted in your remarks have made changes in the composition of the board of directors by bringing in more independent directors. Have they also reached into the management level, in the level of senior vice-presidents, in the United States?
Mr. Davidson: To my knowledge, that is not the focus at all. One of the guiding principles is that there should be a major distinction and separation between the management of the company and the board of directors, that there is too much commonality. The chairman of the board should be a different person than the chief executive officer, which is not the case and historically has not been the case in many large corporations. They are trying to avoid interfering in management but to make a distinction between the board and the management group.
Senator Stewart: Focusing on the relationship between the Internal Revenue Service and TIAA as an illustrative case, I assume that it was the alleged attempt by TIAA to change society that activated the interest of the Internal Revenue Service.
How much of the TIAA portfolio could be thought of as directed toward involving changing society? My impression is that their holdings were extremely broad -- perhaps not an index, but very broad.
Mr. Davidson: That is a good question.
TIAA has investment in more than 2,400 corporations in the United States, just to set the framework here. They are not looking at changing the practices of those corporations all for the purpose of social benefit. Nonetheless, there is a foundation or a guiding approach in their investment selections. They would want to invest in companies that have policies and principles in terms of the products they produce and how they deal with their customers, their employees, and their shareholders. To some extent, it cuts through everything they are doing.
We talked about social change. What I just described is perhaps not as radical as you were contemplating; maybe it is social responsibility. There is a foundation there. If I could go back to my characteristic quote, I do not think it is something that they are using to make their financial decisions. They want returns as well, but they are doing it on the foundation that they select the right companies to do that.
Senator Stewart: I do not know whether this is a question that you can answer; if not, I am sure you will say so.
In the case of the interest of the Internal Revenue Service, who initiated it? Was it some of the corporations who felt that TIAA was meddling?
Mr. Davidson: I do not know the real origin of it. I know the recent initiative was by the IRS itself. I do not know to what extent discussions preceded that.
On that issue, I share the fundamental underlying concern that there is a degree of disgruntlement by the corporations that these investor groups, in the form of public pension plans, which are shareholders, are actually trying to change the governance practices of the companies that they own. You will see in the guiding principles by CalPERS that there should be some collaboration by the institutional investors -- if I can read between the lines -- to add to their muscle power. There has been some disgruntlement by the corporations that perhaps this should not be taking place. Perhaps it is undue influence. Perhaps they are trying to bring about change in strategy and direction in the company. I know that some of that was at play in the U.S. and may well be an issue here. The question is obviously for you as to whether it is out of line for a major investor to try to bring about some changes in the composition, behaviour and structure of the board.
To return to your specific question of how this started, I do not know the origin. It has been brewing for many years. It is not just the General Motors or the Exxon reaction. There are hundreds of examples of companies that did not want to deal with this issue when confronted by the public pension plans.
Senator Tkachuk: I am also interested in the TIAA and the IRS and the definition the IRS would use to cause a pension fund to be taxable. What would they have to do?
Mr. Davidson: If I can give you my interpretation without looking at the specific terms of their regulations, they have regulations which say that if the investment activities of the fund -- and this is my paraphrase -- are not for the sole purpose of increasing the financial return to the shareholders, then they risk being an investor for purposes that should be taxable. In other words, they would lose their tax-free status.
Senator Tkachuk: They are a business?
Mr. Davidson: Yes. That is my interpretation. It may well be worthwhile for this committee to look at the specific regulations of the IRS. Essentially, that is the meaning of it.
Senator Tkachuk: We had a number of discussions over the last few days on this corporate governance issue. You mentioned a question of partnering with CalPERS.
Pension funds, mutual funds, and people who hold large holdings can be treading on grounds that would almost make them considered insiders. In other words, their actions reflect on individuals who may hold stock in that company for the better or for the worse.
The point is: Do I, as a shareholder, have a right to know when a particular pension fund obtains a large stake of a public company? If it is a takeover, as soon as it hits a certain percentage, then rules and regulations apply which allow me, as a shareholder, to know that someone is moving in. Is a pension fund moving in? Should there be disclosure laws that perhaps have a new definition so that the public and the other shareholders would know that this pension fund is moving into the company and they have obtained a 5 per cent stake, which would be a huge stake in the company? If it was me doing it, then it would be a takeover.
Mr. Davidson: There is a rule in the United States, namely, the 10-per-cent rule, which states that if any individual or organization -- whether it be corporate or trust fund or pension fund -- takes a position in the company in excess of 10 per cent, it must be publicly exposed.
The Chairman: The same rule applies in Canada.
Mr. Davidson: Yes, I believe it applies in Canada as well.
Senator Tkachuk: It does.
Mr. Davidson: It may be a question of whether 10 per cent is too high. I do not know whether that applies to mutual funds or public pension plans in Canada. I believe it would. I believe it applies to any investor, regardless of the organizational entity. The question would be whether that barrier is too high or whether there should be something more than public disclosure.
Senator Tkachuk: Once they begin to get intimate with the board of directors -- that is, commence discussions and meetings -- should they be considered insiders?
Mr. Davidson: "Insiders" is a very specific word. Perhaps I could use something else. "Inside trading" suggests something that we are not suggesting here.
If I interpret this correctly, public pension plans -- and I will restrict my comments to them -- have a relationship with management which gives them inside information or an inside track. The objective of these plans is not to run the company, but to improve its financial performance, especially those that are targeted every year, to get a better return.
At one time they would try to change the behaviour and even select companies based on where they operated. For example, they would not deal with companies that operated in South Africa. They would have more responsibility in their products. Times have changed a little in that regard.
It is my interpretation and my experience that there is less of a relationship between management of the company and the institutional investor than you may imagine.
Senator Tkachuk: Perhaps I am not making myself clear. Let us say there is a large holding by a pension fund and they are becoming dissatisfied with a particular company, perhaps for reasons other than return, and they are beginning to remove themselves.
Because they hold such a large stake and therefore have such an impact on the stock, to protect other shareholders should it be public information immediately that they will be dislodging themselves from a certain company? Their impact on the stock would be great and shareholders could be hurt by them selling stock rather than holding it.
Mr. Davidson: Are you suggesting that they should not only disclose when they purchase shares in these companies but also when they plan to sell?
Senator Tkachuk: Yes.
Mr. Davidson: Advising when they plan to sell may be difficult. As to when they sell, if it were a large shareholding, I believe the 10-per-cent rule may also still apply.
Senator Callbeck: First, I wish to compliment you on an excellent presentation. My first question is on the holdings. I see the on the percentage of holdings index that CalPERS is at 43 per cent and TIAA is at 73 per cent.
I understood you to say that those index holdings have no influence on corporate governance.
Mr. Davidson: That is my understanding.
Senator Callbeck: Why then would they have such a large percentage of their holdings there?
Mr. Davidson: This is a certain degree of wise investment policy here. Because of the size of these funds, they will restrict some of their investments to direct investments and others to take advantage of index funds that are performing very well. It may be just due to the sheer magnitude of effort that would be required if they were more active on a one-to-one basis.
Senator Callbeck: You mentioned that CalPERS establishes targets for corporations in which they invest and that if they do not meet those targets, they go public. You stated that there have been changes in directors and so on. Have there been any situations in which the press has had an influence on the value of the stock of those companies?
Mr. Davidson: I could not say directly. I should clarify that CalPERS and other funds go public on who they intend to target this year. They are not looking at it retrospectively on the actual performance and what could have happened. They put out their targets, sort of like a New Year's resolution, and those are published widely. They announce the companies with which they will sit down during the year to try to improve their performance.
Whether that has caused a distortion in the stock market, I cannot say. I do not know. Perhaps other people are reading it and thinking that they did not realize how bad the performance level is of a certain company. Some of those companies are 90 per cent below the sector performance. I am avoiding the word "dogs," but these are underperformers. I am sure that would have some impact on other investors.
Senator Austin: It would have an impact in two different ways. People may sell because they see that the company is not performing well. Others may decide to buy a stock if CalPERS is going in to improve the performance.
Senator Callbeck: Do you think that Canadian pension plans should adopt an active stance such as CalPERS has?
Mr. Davidson: I believe that some of the larger funds already are more active, in a more Canadian way. They are trying to bring about change in corporate governance, board of directors' structure and independent directors. The Canadian way is less public and maybe less confrontational.
That is an individual choice by the funds. There are many smaller funds which are dutifully investing, as best they can, and wisely in many cases, which would not want to embark on such measures.
Senator Callbeck: Should Canadian funds be more public? Should they go public as CalPERS does?
Mr. Davidson: There is a lot of advantage in making public one's interest in certain companies. It can have a significant impact in improving the return. It is a question for those funds to resolve. There are many funds in the United States that do not have a public profile on this. CalPERS, being the largest, has adopted that as a strategy. Each fund must accept its own strategy.
The Chairman: I have a supplementary question on the basis of your response to Senator Callbeck. I want to push you somewhat.
You said the funds should be active, but in the Canadian way. It is interesting that the exact phrase "the Canadian way" was used before this committee a year ago by the CEO of one of our country's five largest pension funds. He was asked to compare the style of activism in the fund he managed with CalPERS and he talked about having meetings with company management. The exact phrase he used to describe the style was "the Canadian way." I noticed you used "kinder and gentler" when describing CalPERS.
Two issues arise from that. First, does "the Canadian way" or "kinder and gentler" really work in your opinion? You have worked on both sides of the border, so you should have a opinion on that.
Second, is the Canadian way, the non-public way, appropriate in the sense that the public, and thereby other minority shareholders, are not informed about what is happening? Should there be an accountability process here? Regardless of whether kinder and gentler is desirable, is the public process in some sense right in terms of keeping the game fair and honest and straightforward and ensuring that all players who are likely to be influenced by this kinder, gentler Canadian way are fully informed of what is going on?
Mr. Davidson: In the current environment where there is a lot more attention to structures of boards and performance of boards, a kinder, gentler way, in the Canadian context, could work. However, perhaps if that went hand in hand with a more public awareness of this activity, that would give "kinder and gentler" a little more support.
It does not have to be combative or confrontational, but it could be public. In the Canadian context, that could be very effective. I do not necessarily endorse the TIAA which is far more confrontational. If it does not come naturally, it will likely not happen anyway. I think "kinder and gentler" could work, especially if coupled with a more public disclosure of what is taking place.
The Chairman: I am looking at the list you gave us of the companies that CalPERS has targeted for 1997. What has been the reaction of company management to being on the hit list? My instinct would be that embarrassment is a powerful weapon. If one were on the management of a company which was on that list, given the publicity that CalPERS attaches to the list, that might have a salutary effect on management. That is pure speculation.
What has been your experience and CalPERS' experience with that list?
Mr. Davidson: My experience, and the experience of several of the major U.S. funds, is that management was really the group behind the dismissal of the initiatives by CalPERS in days gone by. It was management that was essentially trying to snuff this.
To some extent, the board of directors was an unknown group in many of these companies. There is one telling story about this. CalPERS or one of the other major funds sent letters to the board of directors care of one of the companies and the letters were returned because no one knew who they were, except for the president and CEO who happened to be sitting on the board. He got his and some time later called them, but did not act on it too much.
Management has been one of the major factors here. I have forgotten the second part of your question.
The Chairman: Is there a significant impact on management, in terms of their behaviour, to be on, for example, the CalPERS hit list?
If I were on the management of Stride Rite, for example, and CalPERS put out a statement saying that Stride Rite has been 83 per cent underperforming over the past five years and set a target for Stride Rite, I would certainly take notice.
Mr. Davidson: There is no question that management has found all of this very disconcerting, especially the public nature of it. It is embarrassing not only to have bad returns but to have them made public.
The Chairman: Does it change behaviour?
Mr. Davidson: Yes. It has changed behaviour. It has changed behaviour in terms of management saying to the board, "We have to deal with this. Some of these are valid points and we will have to implement some of these recommendations and principles. Let us start to deal with this rather than just rebuff it." Management has been a driving factor behind that.
Senator Austin: I join with my colleagues in thanking you for your presentation. You are hitting a lot of the right notes in terms of the areas which interest this committee.
I wish to begin where the discussion between you and Senator Kirby left off, but it is only with a definition that I was given by someone in the mutual fund industry in discussing this topic. This was a definition given to me privately, and I will now share it with my colleagues. It described Canadians in this industry as decaffeinated Americans.
Mr. Davidson: A recent statement I heard is that Americans like to make money and Canadians like to count money. That may be a factor here in documenting the process by which all of this takes place.
Senator Austin: You started your presentation with a key point. The U.S. political and economic systems have been far more adversarial in their makeup and character. After all, the U.S. began antitrust legislation with the trust busting of Teddy Roosevelt's time and the regulatory period of the New Deal. They also led the use of the state in acting as a referee for activity in the private sector.
Canadians have tended to rely more on peace, order and good government, in the sense that we have looked to government to deal with the ills more than we have looked to the adversarial process in society to identify and correct those practices.
This committee is trying to find out whether the existing system in Canada has such a useful diversity of stakeholders that they do watch one another in this industry and, therefore, the presence of government in terms of regulations or guidelines can be less hands-on because the exchange of activity among the stakeholders will keep the system open, transparent and honest.
We have a mutual fund industry with a different approach -- more passive in some ways and more interventionist in others -- a public pension fund industry and an entire system of what the U.S. calls 401Ks; RRSPs and various self-managed systems.
Are you satisfied that the U.S. system, as it is now practised, is transparent? Is the objective of governance transparency or does it move over also to performance management by the activists in the U.S.?
Mr. Davidson: In the current situation in the United States, as I have described it, what is perhaps noticeable is that there is no regulatory mechanism for the public pension funds. There are initiatives by the Internal Revenue Service, there is the potential for legislation, but there is not a regulatory agency. Regulatory agencies are not exactly in vogue these days in most countries and there have been some problems in the past.
The expectation is that by setting the rules and guidelines -- and this is very much a U.S. approach -- and by using something a little stronger than persuasion, the organizations will regulate themselves and will perhaps, as Senator Callbeck was pointing out, by the public nature and disclosure of their actions, be forced almost to self-regulate.
That seems to be the trend in the United States. I do not think there is serious consideration of having a new regulatory agency put in place for public pension plans. There are enough mechanisms that could be used under the other alternatives such as the laws and the IRS that would suffice.
Senator Austin: We heard here from previous witnesses that the pension fund industry itself has a solidly established concept of fiduciary duty and responsibility based on the common law and the interpretations of courts and that they practise them so aggressively that essentially they are self-regulating. Are you comfortable with that idea, in the U.S. or Canada?
Mr. Davidson: I cannot speak to the Canadian situation, although I do have some direct experience with some of the public pension plans.
I think they are very cognizant of it. There may be some differences in the composition of the boards of these plans between Canada and the United States. There are more outside members on some of the U.S. plans than perhaps there are in Canada. This is a separate and elaborate committee structure on investment in the United States that perhaps relies more on outside expertise. In the United States, there is an effort by these public pension plans to fulfil their fiduciary duties in the right way and they are always cognizant of it. Their approach is quite different in the United States.
Senator Austin: Who watches them in the United States?
Mr. Davidson: There are state requirements for filing of information with the state every year, in terms of the board practices, board composition, board minutes and some of the committee structure. The California regime within which CalPERS works is very elaborate. I have not gone into that in much detail but the state laws are very elaborate. That is because they were initially creations or agencies of the state. It is quite an elaborate reporting mechanism.
Senator Austin: So they have pre-audit tests, in effect? They have guidelines laid down by state legislation for CalPERS?
Mr. Davidson: I do not know what you mean by "pre-audit" tests.
Senator Austin: Do they have to meet certain standards of governance in the decisions for investments processes. Are they limited to certain grades of investment? Are there structures for what they can buy and the diversity of their portfolios?
Mr. Davidson: It differs from state to state as to whether the conditions and regulation of the funds go as far as indicating their investment policies.
Senator Austin: What is the case for CalPERS?
Mr. Davidson: For CalPERS there are some general guidelines but it is not specific in terms of certain bonds or certain quality of stocks.
What underlies this is a belief that if the structure, processes and reporting mechanisms are in place for these large funds, that will be sufficient, without overly influencing their day-by-day decisions on investments. The common theme in the U.S. seems to be to put in place the proper structure and the processes. Frankly, that is what these funds are doing with the corporations in which they have invested. They focus on corporate governance issues in the belief that by approaching that properly the companies will be able to improve their strategy, their operation and their performance.
Senator Austin: Let me ask you about accountability to the stakeholders. Transparency is one issue, as are performance and accountability to the stakeholders. In Birkshire Hathaway, for example, Warren Buffett publishes all the requisite information required to be published. If the shareholders do not like his performance, they can sell the stock and move on.
In a public pension fund, what choice do the teachers who benefit from the fund have, whether they are earning benefits or receiving them, if they do not like the performance of the public pension fund?
Mr. Davidson: I do not know the legal requirement, but I believe they do not have much choice. I believe that contribution to these funds is a requirement if one is a college professor. I do not believe there is an opting-out provision.
Senator Austin: Do they select their managers? Can they change their managers?
Mr. Davidson: Do you mean the managers who manage those investment funds?
Senator Austin: Yes.
Mr. Davidson: Not directly, no. But they would have voting rights for members of the board. In CalPERS, for example, there are a number of independent directors on the board, the idea being that you need to have an infusion of outside expertise. The elected members would have all the privileges.
Senator Austin: Should there be public guidelines for the selection of those important people? I would not want a committee of senators to decide how to conduct an open-heart surgery operation. There are one or two senators from whom I might take advice, but not a committee of the Senate.
How are the qualifications established objectively so that the stakeholders know that the people who are managing their funds are trained and experienced?
Mr. Davidson: Are you referring to the membership and board of the funds rather than of the companies in which they have invested?
Senator Austin: Yes. I am watching the watcher here. They are watching the companies, but who is watching them?
Mr. Davidson: I understand your question. By and large in the U.S., there are very few prerequisites for elected members of the board. It is quite different for independent board members. Once elected, board members can act as they choose. They will be held responsible for their results and may be removed from that board, all within the framework of what the State of California allows.
Some of the funds -- as they do for some of the corporations in which they invest -- have quite specific guidelines for what they think are the desirable attributes of a board member. It goes well beyond mere independence. It may be certain skills or expertise.
Having said that anyone can run and be elected, there has been a significant shift in the last few years in most funds to try to ramp up the expertise on their boards. The boards themselves are more active in making decisions for the funds, as they should be. In other words, they do not delegate all this investment decision making to some subcommittee that does not have a strong link of accountability.
Senator Austin: I am rather interested in the growth of the fund management industry, broadly defined, on a global basis. When you see Merrill Lynch acquire Mercury, for example, and put itself into the European market, and you see someone take a piece of Peregrine in Hong Kong, and so on, it appears that this industry is moving over time toward fewer and fewer hands. The people who manage funds will have larger and larger funds to manage. We have heard from other witnesses that the larger the fund the more efficient, the more effective and the lowest cost per unit of benefit to stakeholders. There is a natural economic push here for larger funds and for integration as these units gain expertise and access to capital.
Do you feel that down through the years we will be looking at a great many securities being managed by and actively discussed by quite a small number of real managers?
Mr. Davidson: I cannot speak to the Canadian situation, although my observation across the border is that there are probably more funds in Canada now than there were 10 years ago, and I believe they are more specialized.
Senator Austin: That is true. On a global basis, there are more funds, but there are also larger funds managed by fewer players. It is quality rather than quantity.
Mr. Davidson: I understand where you are going. I spend a lot of time working with the fund industry, and there clearly is advantage of size, but the market is also demanding boutique kind of specialization and segmentation. In the United States, as I believe is the case in Canada, there are a lot of new funds that are very specialized, and they are doing very well. Their secret is to try to get their operations to a point where they are not at a disadvantage with the large funds in terms of volume. They are very attractive in the marketplace.
Again, not speaking to the Canadian situation but to the question of the global trend, I think you will start to see more funds, not fewer.
Senator Austin: But fewer fund managers?
Mr. Davidson: I am talking fund managers.
Senator Austin: Do you mean more fund managers?
Mr. Davidson: Yes. There are more companies that are making available fund products, if you like. There are many more in the U.S. than there were five years ago or even last year.
Senator Austin: In relative terms, are the "fewer" growing at the expense of the "many"?
Mr. Davidson: I do not think so, although we must be careful. There is such an infusion of cash into the mutual fund industry, the last few years have been so unusual, that it is difficult to trend it.
I was speaking with someone in the U.S. yesterday who foresees that this trend will continue for perhaps the next 10 years while a certain generation of us continue to invest in retirement plans now that homes have been purchased and that kind of thing. They will be directing their funds more to mutual funds and pension plans and we may continue to see growth in that industry.
When there is growth in that industry, there will be a number of new players every year who will want a slice of that and who will have a market approach on how best to do that. We must be careful not to take the actions by some of the investment bankers as being the same as what some of the fund managers may be doing. There is more proliferation in fund managers than there is in investment bankers. They are all marrying each other as fast as they can.
Senator Austin: Is there any concern about the number of "products", if I can call securities that, which are available to these rapidly growing pools of capital? Is enterprise producing enough new securities for all of these funds to chase?
Mr. Davidson: There is no question that the mutual fund industry has such an volume of cash to invest that it is taking an increasing share of the equities of U.S. corporations. I imagine that there may be some consideration as to whether that is true in Canada. I think it may well be.
In the United States, there is no question that there is a huge infusion of cash into that industry, and they are investing in U.S. corporations. It is a trend that would appear to be continually increasing.
Senator Austin: I wonder whether the business sector is also creating more companies which are offering more securities at a rate that permits the market to work effectively. The old rule of economics is that if you limit the supply and increase the demand, you can get some serious distortions.
Mr. Davidson: There are some new securities that have been made available. The existence of index funds itself is one of the answers to that question.
There is a degree of uncertainty in corporate America as to how to deal with this large investment by mutual funds. Their stake in the company is increasing all the time and they are not used to this. That is the underlying issue behind all this discussion on public pension plans. They happen to be one of the major players in that institutional investment community and corporate America is digesting that as quickly as it can, but it is a totally new shift.
Senator Kelleher: I have enjoyed this discussion very much. I should like to shift your focus away from the public pension fund industry to the mutual fund industry, which in a sense we can call private as opposed to the CalPERS type of fund.
During our discussions last year on corporate governance it came to our attention that there did not appear to be a lot of supervision and regulation with respect to these pension funds, whether public or private. In there I include mutual funds.
Some of us have the feeling that the corporate governance standards of the mutual fund industry in Canada has not been of the highest standard. In the last few years we have heard a lot of stories about various practices that are carried on by some people within the mutual fund industry. It is not a blanket condemnation of the whole industry, but we have had a number of highly publicized incidents of fees, front-end loading and so on.
Are you in a position to compare the corporate governance standards of the mutual fund industry in Canada with those of the United States? Are there more standards and regulations in the United States than there are in Canada? Are we lagging behind the American industry in this respect?
I acknowledge that the mutual fund industry here in Canada has lately been trying very hard, and I think somewhat successfully, to pull up its socks and bring in more self-regulation.
Are you in a position to express an opinion on that?
Mr. Davidson: I can certainly speak to the U.S. situation. I am not as conversant as you would probably like me to be on the Canadian situation. I do know some of the funds and I do know that they have an industry association which is looking at this issue.
In the U.S. there is a changing situation as well. There is recent federal legislation in the U.S. which addresses both the product side, which I would call the mutual fund side, and the distribution side of that industry. One of the major features in that legislation is to increase the role of the SEC in Washington. It is very specific on this issue.
This legislation came about after many years of input from the industry. There is recent legislation in the U.S., the name of which I can provide, which does enhance the federal framework within which the industry must operate; both distribution and what I call product or fund companies.
That is a recent initiative and was a shift away from much of the state law that prevailed. There is a lot written on this new legislation that talks about that shift from state regulation and administration to federal administration, and that must be handled very carefully in the United States because there is still a filing requirement for all new funds and securities that are offered for sale in any state, as there may well be in Canada in the provinces. There is also a filing requirement for any distributor that does business in that state. Historically, there has been much more concentration of authority at the state level than there has been federally and this new legislation shifts that emphasis in the mutual fund industry.
Having said that, there has been a major initiative by the mutual fund industry in the United States to adopt new practices. It has looked at its code of conduct for its members; it has looked at its practices and how it disseminates information. There are specific requirements in this new legislation, for example, on how these funds are required to calculate the yield on investments. We may pick up a financial paper and see that some fund has had a five-year return of 29.3 per cent, and investors make decisions on that basis. There are requirements in this new legislation for a standard approach on how the yield is calculated so that an uninformed investor has some assurance that there is a common basis.
It is a large issue but there is a legislative and regulatory framework in the U.S. that applies. To a great extent, there is a higher degree of self-regulation in the mutual fund industry in the United States as well in recent years. I am not really in a position to talk about the Canadian context, however.
Senator Kelleher: Would it be fair to say that the reason this new federal legislation has come in in the United States is because, notwithstanding the attempt by the industry there to more self-regulate, there has been a feeling that it has fallen somewhat short and that therefore the federal authorities had to step in?
Mr. Davidson: There are a number of issues. It is a very complex issue and I will not try to give it a brief answer.
There were initiatives which were causing problems for the industry itself, and there were some issues which were causing problems for the public. The yield calculation is one example. They thought there needed to be better public assurance that what was being presented was on a common basis.
Senator Kelleher: It does up here too.
Mr. Davidson: I am sure there does. It is a complicated calculation, and should be.
Having state authority and regulation over many of the funds and their distributors was not working well for the industry. Quite frankly, they said that it brought it down to the lowest common denominator. What one state required as the minimal level of reporting and filing was the direction of where the regulation administration was leading, and they did not see that as positive. They would have to file in 50 states. Essentially, it has become a national and maybe even a global business. It was not one that just pertained to state jurisdictions.
There are a host of issues behind this.I do not think it was an immediate reaction to a concern that there was wrongdoing taking place. This was an area which had not really been examined and changed for many years in the U.S., perhaps since the 1940s. It was long overdue to look at how the industry itself had changed and to put in place the right mechanisms.
Senator Kelleher: Would you be kind enough, as you have offered, to send us some of the documentation with respect to this new federal legislation?
Mr. Davidson: Yes.
The Chairman: Is it fair to say that these changes in the mutual fund industry, a number of which, as you pointed out, are coming about voluntarily now from the industry, have in fact come about only because of public pressure which caused the industry to conclude that it was better to take charge of the reform than be reformed without being in charge?
Mr. Davidson: In the U.S., that is largely true. There was a recognized need by the industry itself that some of these things had to take place and the public pressure on these issues put it on the agenda at a certain point in time.
The Chairman: In the absence of public pressure it probably would not have occurred or would have occurred much more slowly?
Mr. Davidson: I think it would have occurred in any event. It is a very segmented market. There was not a strong industry association, if you like. They were all doing their own thing in the various funds. I think they saw that there would be some mutual advantage in doing this through an industry group.
The Chairman: All of the activism you spoke of was in public sector plans. It is interesting that you never spoke of activism in private sector plans. You then went on to talk about legislation, which you called a public plan version of ERISA as opposed to a private one.
I do not understand why, from the point of view of the beneficiary of a pension plan, the rules would be any different whether the employer happened to be a private sector or a public sector company. However, throughout the discussion for the last hour and one-half you clearly made that distinction. In fact, you said very little about private sector plans.
Why should there be a difference? Why have private sector plans in the United States been so passive?
Mr. Davidson: I am not trying to find the exception to the rule, but there are a few exceptions of funds that target certain kinds of companies that have certain practises that would be more socially aligned to the interest of some investors. They are quite the exception to the rule, however.
In my personal opinion, there are very few reasons, if any, why there should be differences between public and private pension arrangements. The U.S. draft public version of ERISA is going in that same direction. The rules that apply to the private plans should apply to the public plans.
The Chairman: Why are the private plans not activist? Let me hypothesize what you said earlier.
You said that management of the investee companies has not been happy with the level of activism of public sector plans. Is it possible that since management of the company of a private sector plan are unhappy with activism impacting on their company, they are reluctant to have the company pension plan become activist in other companies for fear that there might be an element of quid pro quo; that is, you lay off my company and I will lay off yours? Is that a potential rationale?
Mr. Davidson: I think it is more fundamental than that. I do not think that is the driving factor. I think it is the membership of the various plans. It may be the greater propensity of school teachers and college professors to have a much greater interest in certain types of activities and investments than of a private fund which has a diversity of participants. There is not a commonality here. A member-driven plan is quite a different creation than a plan of which anyone can become a member.
The Chairman: You are saying that a member-driven plan is different than an employer-driven plan and in the public sector the plans are much more member-driven than employer-driven?
Mr. Davidson: I would expect that the same is true here in Canada; that there are member-driven plans here in Canada as well. That is the fundamental reason. There are interests that relate to a certain group of people who, as members of that plan, want to bring about certain things.
The Chairman: I will give you a three-point summary of what I think you have said today. Tell me whether I am reasonably accurate.
First, you favour more activism rather than less. That is to say, passivism on the part of large investors is not something you necessarily espouse because you seem to think that greater returns, changes in management behaviour and improved performance come about as a result of activism that would not come about as a result of passivism. Is that a fair conclusion?
Mr. Davidson: We may get lost in what we mean by "activism" and "passivism." Perhaps I should give my own three-point summation.
The Chairman: That is find. Go ahead.
Mr. Davidson: First, there is a lot to be gained by a more active approach by the public pension funds in the areas of corporate governance and bringing about change in the companies in which they invest, regardless of how you measure it.
Senator Stewart: To produce better return rather than to change society.
Mr. Davidson: Yes. I am talking about improving returns to their members.
The Chairman: Yes; not achieving a social objective.
Mr. Davidson: I am not saying that in terms of agents of social change. I am talking about their primary motive of serving their members. There is a lot to be gained by doing that. Returning to Senator Callbeck's question, there is a lot to be gained by doing that publicly.
The Chairman: That was my second point. What is your third point?
Mr. Davidson: Third, there are three types of mechanisms at which one can look. There is a regulatory agency, which is not in existence in the United States, by which public pension plans could be monitored or regulated. Much can be gained through persuasion, guidelines, pushing the issue back to the industry and pushing it to react. Perhaps that is a role for a Senate committee.
Tax requirements and tax legislation can come into play here as well. There are a number of mechanisms that can be used to take this in the direction that this group chooses to take it.
The Chairman: We agree on two of the three points. I thought you were stronger on activism. I did not mean aggressiveness, but activism in the sense of not being simply passive index investors.
Mr. Davidson: I am trying to say the same thing. There is much to be gained by being proactive in corporate governance policies by these funds in dealing with corporations.
Frankly, there is a lot for the corporations to gain by having these issues put under scrutiny. The world has caught up with this issue. There is a lot going on by the very initiative of the companies themselves now, not just by the funds.
The Chairman: There is a dynamic pressure that is changing?
Mr. Davidson: Exactly. One must see it in a continuum.
The Chairman: Mr. Davidson, on behalf of the committee, thank you very much for coming here this morning. It was a stimulating discussion.
Our next witness is Mr. William Riedl, President of Fairvest Securities.
Mr. Riedl, I know a fair bit about your company. However, given that you are an investor who specializes in activism, it might be useful, as a prelude to your opening remarks, if you gave my colleagues a two-minute version of your role and then proceed to your opening statement. There are a number of questions we would like to ask you and, having had the advantage of hearing our discussion with Mr. Davidson, you know the areas in which we are interested.
This first wave of hearings gives us an overview of the area of institutional investors in Canada. When we reconvene in late February, we will move into talking to individual companies, institutional investors and individual pension funds.
Mr. William Riedl, President, Fairvest Securities: My intent is to give you a brief description of Fairvest and its activity and then a brief opening comment. Hopefully we can move quickly into the question and answer period, because I think that will be the most productive.
Fairvest Securities started as Allenvest Group Limited which was founded in 1983-84 by William S. Allen. It was a small brokerage firm.
The Canadian Tire incident gave the firm some prominence because it coalesced a group of institutional shareholders who were fighting what they thought was improper conduct. It got into the key issue, which is really the vote. The most important part of the asset of the shares that an investor owns is the vote. In that particular case -- and others we can go into if you wish -- problems occurred because the votes are not attached to the shares or they can get into what is called jewel class capitalizations where there is a super voting share and a minority or subordinated voting share. This can lead to come conflicts.
Bill Allen died in 1991, which is when I took over as the CEO. In 1993, we changed the name to Fairvest.
In 1991, we tried to determine what was the best product that the firm had. The board of directors clearly saw that there was a need in this area to provide to institutional investors in Canada research, advice and analysis in the area of corporate governance and shareholder rights.Therefore, in 1991 we chose to focus on that.
The main product we developed which gives us a relatively large client base of institutional investors is called a proxy review service. When a company has an annual meeting or a special shareholders meeting at which certain items are to be voted on, we, as our main business product, analyze those issues and quite often make a recommendation. Our client base receives those recommendations, and then the institutional investors make up their own minds about how they will vote on those issues.
The more contentious ones, which constitute a significant number, have been the so-called shareholder rights plans, which were poison pills, and now executive compensation.
Shareholders normally get to vote on executive compensation in the area of the option plans. Also, director compensation is getting into the area where directors of firms are being offered options.
That is a most significant event and the practice needs to be protected as it goes forward. The shareholders are the owners of the business establishment and their voting rights need to be protected.
As you are well aware, in the amendments to the CBCA, there are recommendations. One of our vice-presidents has been involved with a number of the groups that have been discussing changes to the CBCA. Our area of focus is on the proxy voting and shareholder communication area of the CBCA.
That is what gets us into the arena. These issues, which are or perhaps should be voted, cause the escalation of shareholder activism. Every institutional shareholder has to be active to some degree. They have a fiduciary responsibility to do so. How far or how active they are then, that is where the differences come. However, as a minimum, they should be voting the shares which they own.
The Chairman: My initial question delves into the issue of whether you or your firm actually go to annual meetings to argue for or against particular propositions. It would usually be to argue against, I assume; when it is "for" management probably has many proxies. Do you simply pass your advice on to your clients, the institutional investors, and then leave them to do their own lobbying or public speaking or whatever? How active are you in that sense?
Mr. Riedl: The answer is that we do not attend annual meetings. We do not own shares in companies. We are in more of an advisory role, an advocate and an organizer.
To focus on the annual meeting you would miss most of the shareholder activism. For the issue to get to the annual meeting and to be on the agenda is, in my view, a last resort. Most of the shareholder activism which is done by institutional investors is done in private meetings, usually with the CEO of the firm.
The Chairman: Do you mean the CEO of the institutional investor or of the investee firm?
Mr. Riedl: I refer to the CEO of the investee firm. That is the typical approach. Sometimes, if that is not working out well, then there is an option to meet with one of the independent directors or a group of independent directors or even the whole board. That does not happen too often. In most cases, it is the meeting with the CEO of the firm. In private discussions, viewpoints are made and some changes occur in corporate governance structure or in corporate activity.
The Chairman: You heard the discussion this morning about the pros and cons of keeping private the fact that such meetings are being held. We have heard conflicting evidence on the desirability, from the point of view of small individual shareholders, of knowing that those kinds of meetings are taking place. We also heard evidence this morning that privacy is the Canadian way, the kinder and gentler approach.
From where you sit watching this scene, what are the pros and cons of greater public exposure and public knowledge about the nature of these meetings between institutional shareholders and the companies in which they invest?
Mr. Riedl: It was the previous chairman of the Ontario Securities Commission who said that sunlight is the best disinfectant. The more disclosure we have of significant events and activities and positions, the better it is for all concerned.
In the earlier discussion about the level for disclosure, a figure of 10 per cent was mentioned. It is my understanding that the level is 5 per cent in the United States, that is an SEC requirement; in Canada, it is 10 per cent. Any person -- and a person is defined, be it a group acting together, individuals or corporations or institutional investors -- who goes over 10 per cent must disclose.
Unfortunately, in my opinion, a number of investment counsellors in Canada for a long time had a legal interpretation that indicated that since they were investing on behalf of a number of different groups, they did not have to disclose. For the last six or seven years, a battle was going on in the background to get them to disclose when they went over 10 per cent.
It has been basically agreed between the regulators and the larger institutional investors -- most of which are investment counsellors who invest on behalf of corporate and public sector pension funds -- that when they go over 10 per cent, they will disclose and on any 2-per-cent change from that, up or down, they will disclose.
At the moment they are doing that on a voluntary basis until the Ontario Securities Commission obtains its new rule written. That disclosure is good because participants in the public marketplace can know when one of these large investors is taking a significant position or changing their position in the shares. The large public sector pension funds have always observed the 10-per-cent rule.
With respect to the private meetings, there is a trend now with respect to what is called the Allen committee of the Toronto Stock Exchange. They are trying to develop some stronger rules about disclosure of activity and to get away from these private meetings.
That is a part of the recommendation. What usually gets the press is the civil litigation side, to be able to sue corporate officers, directors and consultants for disclosure of misleading information. It is how a corporation will disclose and how they will communicate information with shareholders that is the important part of the Allen report.
In short, they recommend that, on a quarterly basis, usually through conference calls, the corporation should meet with representatives of the shareholders, including individuals from institutional investors and analysts of brokerage firms. A tape of that conference call is available to the public after it has occurred. The public can phone in and listen to what occurred there. A number of larger companies are already using this process.
It is an excellent disclosure, then, of what goes on in these high level communications between large shareholders and representatives of all shareholders. It discloses the questions that are asked and the answers that come to management. If you have not dialed into one of these lines and heard what has gone on, I strongly recommend you do so. It is a good way of becoming quickly educated as to what is happening.
The Chairman: You talk about the 10 per cent in Canada and the 5 per cent in the United States. Would you favour lowering the 10 to 5 in Canada?
Mr. Riedl: I guess I would be neutral on it. In the United States things are very different. To us, CalPERS and the teachers and college fund may seem big, but in the U.S. scheme of things they are quite small. It is more typical in the states that institutional investors, as large as they may be, only hold 1 per cent or less -- 2 per cent would be large -- of a corporation, so it is quite significant when they go over 5 per cent. In Canada, institutions very quickly get up near 10 per cent. For instance, OMERS, the last time I counted, had 22 or 23 holdings where they were over 10 per cent and needed to disclose. We will run into a problem if you do drop it down to 5 per cent in Canada. We will have information overload.
The Chairman: We will have a telephone book.
Senator Stewart: Mr. Chairman, you anticipated one or two of my questions, so I am a bit ahead of the game even before I start.
You heard the evidence we were given earlier with regard to the apparent effects of the aggressive monitoring in the United States by CalPERS of the targets during the 1982 to 1987 period as compared with the achievements in the 1987 to 1992 period. Is there any investor in Canada that engages, to your knowledge, in the kind of aggressive monitoring that CalPERS engages in in the United States?
Mr. Riedl: I am not aware of any in Canada that take a similar approach to that. Again, the U.S. situation is quite different. It relates to the comment I made before that most of CalPERS's positions are quite small, 1 or 2 per cent of the total. That approach is more confrontational and it gives them a high public profile, but in Canada most institutional investors are well above that figure. The Ontario teachers hold, on average, about 4 per cent of every major company on the TSE where they invest. They invest mostly in TSE 300 companies.
Senator Stewart: The reverse side of the coin of what you are saying seems to be that these major institutional investors in Canada do not need to resort to the aggressive monitoring that CalPERS does because they own such a large percentage of the shares. A quiet luncheon should be sufficient to change the fat cats in Canada.
Mr. Riedl: Not quite, not the quiet luncheon. We should not just focus on the public sector pension funds. We should also bring in the corporate sector pension funds. Very few of them have their own internal investment management. In most cases, they have put the equity portion of the pension fund out with typically four investment managers in Canada, which typically will be the investment counselling firms who are acting not just on behalf of that one corporate pension fund but, in some cases, on behalf of more than 100 corporate pension funds, probably mingled in with public sector pension funds, mingled in with high-net-worth individuals, and mingled in with mutual fund money. When you add all that together, they quite often have a very high percentage of the corporate issuer's shares, and that is what gives them the clout to be able to sit down and say, "We own whatever, 9 per cent or 19 per cent or 6 per cent of your shares, and we have been taking a look at your corporate governance structure and we have some concerns in this area."
It is not done publicly because more can be accomplished in private discussions. The public arena is the last resort, from what I have seen.
Senator Stewart: You seem to be suggesting that we should be -- I hesitate to use the word but I will -- complacent. You seem to say, given the structure of corporate investment, whether it is big pensions or institutional investors, that we do not need the kind of aggressive monitoring that CalPERS undertakes, that the watchers are quite awake in Canada.
Mr. Riedl: Yes.
Senator Stewart: I suppose you would argue that the condition of our industry generally is good, to some extent, as a result of the watchfulness of the watchers.
Mr. Riedl: I would go so far as to say I consider the level of institutional investor competence in Canada higher than it is in the states. It is much more focused up here. In the United States, as the previous speaker mentioned, with TIAA-CREF trying to monitor 2,200 companies, they have to take a much broader approach. CalPERS has to monitor, I think, 3,000 companies when they get into their world arena. It is absolutely huge. So they need to take an approach using a screen to focus on a smaller number of companies that they can deal with.
In Canada, a number of institutional investors only choose 40 or 50 companies so they get to know those companies much more intimately. Their screen is used to select the corporate issuers in which they will invest. They do not need to use the approach that CalPERS is using, which is using the screen to select the targets for shareholder activism. The Canadian institutional investors are looking more at their whole portfolio to see where they are happy with the way the corporation is being managed, its governance structure, or to see areas in which they should be doing something.
In Canada there is also a focus on the ones where there are poorer returns, or the ones where the net asset value of the company seems to be well above the market price. Much of what the Ontario teachers plan does ends up being in the public arena, whether they want it to be or not, so just through the media you can follow the way they approach shareholder activism. The main one which has come to light lately has been the joint venture, TMI-FW, which is a group of about a dozen very talented people under the leadership of Thomas Taylor, managing money on behalf of the Bass family. That has been going on for over 12 years. The first time I heard of them down there must have been 15 or 20 years ago.
However, it has only come to light in Canada recently because of the venture with the Ontario teachers. Once it got into the media, the media has taken a great interest in it. I am not telling any tales out of school. My knowledge is based on what I read in the media, with respect. Thus far, there have been five companies this year in which have been over 10 per cent which needed to disclose. Their activities are mostly reported in the media. It is not the Ontario teachers doing that, it is their partner which is doing that activity.
Senator Stewart: Have you given any thought to the implications for the kind of practice that now prevails in Canada, the implications for the practice of moving away from the 20-per-cent rule where there would be more investment in the United States, for example?
Mr. Riedl: I am not sure what your question is about the 20-per-cent rule.
Senator Stewart: It is about foreign holdings.
Mr. Riedl: That is not an issue in which Fairvest is involved.
Senator Stewart: You have not put your mind to how that might impact the Canadian practice which you seem to suggest works pretty well?
Mr. Riedl: I believe so. The ceiling on 20 per cent in foreign property investment is another issue. I do not have any strong opinion on it.
The Chairman: You said a minute ago in response to Senator Stewart that the public arena should be the last resort. I should like to understand why you say that. Several members of this committee, including myself, who sit on public boards have clearly recognized that corporate governance, the behaviour of boards, et cetera, changed radically when the TSE guidelines -- and they were only guidelines -- led to a whole bunch of things having to become public or it being suggested that they become public. If you listened to Mr. Davidson this morning, you heard there is not much question but that the potential for embarrassment associated with public knowledge and media coverage of your activities is what leads to a change in behaviour. We are all human beings, and that is natural. I am curious as to why you think the public arena becomes the last resort rather than, perhaps, the first resort.
Mr. Riedl: I believe in your statement you have the answer. It is the potential for public disclosure and embarrassment. The potential is what can have effect. If we are dealing with a corporate CEO, or a CEO's board, his preference will be that he can deal with these issues and resolve them privately. There is not then the embarrassment of a public profile on the issue.
From the investor side, knowing that there is a preference to resolving conflicts, if it is down to a conflict, because it may not even get that far, it can be expressions of opinion and just influencing rather than conflict. If it is a conflict, it is better to keep it in private, where there is a better chance of resolving it. Even looking at the media these days and seeing the coverage on the postal strike, we see that it becomes difficult for these issues to be resolved once they have a public profile.
The Chairman: Do you say the fear of publicity is almost as powerful as the publicity itself?
Mr. Riedl: Yes. It is even stronger. A stronger influence that can lead to change of behaviour is the fear of the issue becoming public.
The Chairman: The fact that the kind of meetings you describe take place without other shareholders knowing that they take place, does that put the other shareholders, the individual minority shareholders, for example, at a disadvantage?
Mr. Riedl: Not at all. As a matter of fact, that brings up a point. We call it the free rider problem. I have seen this discussed in many places. It can be a bigger problem in the states.
If you want to read more about CalPERS, there is a great Canadian source. It is a book put out by Industry Canada, entitled, "Corporate Decision Making in Canada." It makes excellent reading. It is a package of great papers all about corporate governance. It contains one whole paper written on the CalPERS model in which it asks if it is applicable to Canada.
Senator Austin: What was the answer?
Mr. Riedl: My reading of it is that it is not applicable.
The Chairman: Why?
Mr. Riedl: I go back to what I said before. We have a very different situation. A Canadian institutional investor is free to choose and adopt the CalPERS model, if they so wish. I would not recommend that they do so. I am not aware of any that have done so. However, there is the freedom of choice.
Senator Tkachuk: The issue I brought up with Mr. Davidson had to do with an institutional investor meeting with management. We have been told here that institutional investors do not sit on boards, or that they often do not exercise their proxies in Canada. Shareholders vote for board members, exercising their franchise, in the hope that those board members will represent their views. They may or may not, which is a different question. However, that is the theory. It seems to me institutional investors want it both ways. They want to be able to sit down with management and influence decisions, but not bear responsibility for those decisions. A board member has certain responsibilities, legal, ethical and disclosure-wise. He or she has responsibilities that fall into a different class because of the position they hold. I am of the same view as Senator Kirby. When a major shareholder like the Ontario teachers pension plan meets with the president and CEO of a large Canadian company, as a shareholder I should like not only to know about the meeting but what has been said. That is a very private discussion. If the meeting is a negative discussion, I should like to know that because it impacts on my stock and, perhaps, on my own personal retirement program.
Are there things we can do to protect the shareholders? I am not so interested in the big guys; they can look after themselves. However, I am interested in the mom and pops with their RRSPs. I am interested in the people who have smaller pension plans that are highly affected by what happens when the Ontario Teachers Pension Plan acts, whether they sell or buy, and other large pension plans of that kind.
Mr. Riedl: I will go back to the free rider because I did not finish that point.
If an institutional investor is effective in changing corporate behaviour, it is because they expect that there will be a better investment return. This benefits all shareholders. However, the effort is being paid for by one shareholder.
One of my pet peeves, being associated with a very small firm on a limited budget, is that on occasion we will do something to improve the benefits for all shareholders. We may only have one or two clients paying for that effort. That is usually the situation, but all the shareholders are benefiting.
It is always helpful to have examples. A takeover bid may occur whereby it proceeds by a plan of arrangement. The key is that the shareholders get to vote on it. The price is well below what it should be or could be. By organizing enough shareholders to defeat the plan of arrangement, in order for the transaction to go through, there must be a renegotiation at a higher price. We have been able to effect that a couple of times. Whatever we do, we try to treat all shareholders equally.
Senator Tkachuk: I understand that.
Mr. Riedl: All shareholders get the higher price, although the effort has been made by a few.
Senator Tkachuk: I do not think anything other than self-interest drives the meeting. Pension plans do not go to a meeting to say, "I want to help out those 2 million shareholders." They go to the meeting to help themselves. When they come out of the meeting, I would like to know -- because it impacts me as a shareholder -- whether they were happy with that meeting or not happy with that meeting.
Mr. Riedl: The responsibility is on the corporate issuer to disclose material information. If it is an important meeting, lawyers will be present. Even if they are not present, there are enough people involved managing a corporation or on the institutional investor side to know that if a significant event has occurred, there is an obligation for that to be disclosed publicly. That is what happens. Either the corporation discloses it, or the institutional investor will disclose it, or the institutional investor will ask the corporation to disclose it.
A case in point happened just last week with Nova Corporation. It was a private discussion during a conference call. In response to a question, Mr. Newall, the CEO of Nova, said yes, they were considering splitting the company into two pieces and that there was a pretty good chance that would happen. That was suddenly material information. They realized that, and there was immediately a public disclosure of that statement in that private meeting.
The Chairman: There is no question that if something goes on in one of those meetings that is material in the legal definition, you must disclose it. I read Senator Tkachuk to ask a softer test. For example, let us assume a big institutional investor goes in to talk to Company X. They were not told anything material, so there is no legal disclosure requirement. They come away with a feeling that this is not so good. Management talked to them, but they were clearly not getting anywhere. Their feeling about the company has gone down a bit or maybe a lot. That is not material.
The point Senator Tkachuk was making is that as an individual investor, should he know not only about the meeting, but should he have some sense of what that feeling was at the end of the meeting? That could be material to what he is saying.
Institutional investors have two big advantages over individual investors. One is that the institutional investor can work on a much longer time frame. The institutional investor will be around for a long time. The individual investor will not be around for a long time. Death does occur at some point. Second, the institutional investor has a much greater tolerance for risk because they can live through the downswings or mistakes in a single investment much more easily than can an individual investor. Those two factors may make it more material -- not legally material -- for the individual investor to know the outcome of the meeting and the feelings that the institutional investor had as a result.
I realize this is a difficult area to legislate or put guidelines on, but some of the evidence we had in our first set of hearings on the CBCA changes and some of the feelings we have seen here relate more to an amorphous feeling that individual investors would be better off if they had a better sense of what was going on, which the institutional investor has but is not required to make public because it is not public. How do we deal with that kind of "feeling" type of problem? That may be the basic question Senator Tkachuk was asking; is that correct?
Senator Tkachuk: You expressed it much more precisely.
Mr. Riedl: The requirement for disclosure should relate more to the transaction that occurs. A meeting could occur, and maybe there are negative feelings. However, if it does not result in any share trading activity, I do not see any need for disclosure.
Let us suppose what was revealed in the meeting led to reason and a decision by an institutional investor to undertake transactions, such as to sell the stock. Let us assume the investors are very small. If there is material insider information and they make a transaction, they could be sued for making a trade based on material inside information. Any investor could be prosecuted on that basis.
If the institutional investor is large, they will presumably report that they have over a 10-per-cent holding. There is talk of lowering the reporting requirement to 5 per cent.
At the moment, we have a hodgepodge in Canada in terms of reporting a change. Once you are over 10 per cent, you are considered an insider. It is unfortunate, but that is the way it is. With respect to most of the provinces, the trade must be reported within 10 days. Ontario is 10 days after the month end. My understanding is that there are recommendations by the securities administrators in Canada, the CSA, to change that legislation so we are all operating under the same basis, which is 10 days. Some people want to know earlier. They want to know within one day.
The figure of 20 per cent was raised. As an investor, if you are over 20 per cent, you have to file Form 23, I believe it is. You have to file the intent to sell, and it becomes a public document for X number of days.
The area you are touching on is already partially in effect, but it could be changed to give faster disclosure and more disclosure.
Senator Tkachuk: Exactly. When a public company has an intent to purchase or an intent to begin negotiations, the securities commission considers that very important to the shareholder, even if they begin negotiations, and they are compelled to issue a press release and are compelled to notify the exchange immediately. Meanwhile, a person who owns 20 per cent of a company is having a meeting with management. That would be the least they could do. They would not be having it unless it is someone's birthday, or something. It would be important.
Mr. Riedl: Yes, but as soon as you get into writing something down, you get into problems of having to define it. If there is a meeting, when is it the type of meeting that needs to be reported?
Senator Tkachuk: I will leave that. I am just asking the question. I just think it is important.
Mr. Riedl: That is not an area that I have given much thought to, other than just in these last few minutes.
Senator Kelleher: I should like to turn back to corporate governance with respect to the mutual fund industry. When Mr. Tom Hockin appeared before us last evening in his position as executive director of the association, he left in my mind little or no doubt but that they, the industry, favour self-regulation. There was some acknowledgement of past sinning, but he said they are now moving to clean this up and that they can handle it.
I should like your view as an observer of the market and one who is aware of the alleged abuses. Do you feel this is sufficient, or should there be some form of regulation or guidelines set out by either the provincial or federal governments in this area?
I do not think anyone on this committee favours over-regulation. We realize this is a dynamic market, and when you are investing, no one will guarantee that you will always win.
Perhaps you could give us your observations as to whether what is in place at this time is sufficient for the average investor.
Mr. Riedl: This is not Fairvest's specialty at all.
Senator Kelleher: I am aware of that.
Mr. Riedl: However, I do have opinions, given my many years of experience.
Senator Kelleher: That is what I should like to hear.
Mr. Riedl: I have an interest in the integrity of public markets. I am a director of the Investment Dealers Association of Canada. With that hat on, I need to take an interest in this area.
I share the opinion of the acting chair of the Ontario Securities Commission that this is an area to be very much concerned about and one that needs regulation. His view is if the industry does not hurry up and get formal regulation, then he has no other choice than to have the Ontario Securities Commission increase its staff to provide it.
I do not think the problem is as much with some of the leaders in the industry. The problem is that so many new firms have started up. The number is approaching 200 mutual fund firms managing and handling people's money. In many cases, independent business people have started up without much experience with all the proper compliance regulations. I know a significant amount about regulation, my firm having been regulated for many years by the stock exchange. The Investment Dealers Association of Canada has been in the area of self-regulation for many years. They have very strict rules and regulations. There are two audits a year on systems. It is important because independent business people may not have the background to know all the safeguards that need to be in place to protect their clients' money. I am talking about honest, hard-working people not being aware of the concept of the co-mingling of funds and keeping them separate. There needs to be a regulatory structure in place.
Most people have a deposit in a bank account somewhere. We had some problems with banks back in the old days because they were not regulated. The U.S. did too, and they came to the Federal Reserve Bank. Unless you have regulation when large amounts of money are accumulated and strict guidelines and regulations where audits are done, things can go astray, even in legitimate operations. There is definitely a need for regulations and compliance.
The Chairman: Mr. Riedl, on behalf of the committee, I wish to thank you for taking the time to be with us today.
Senators, this completes the opening phase of our hearings.
The committee adjourned.