Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 5 - Evidence - November 18 meeting


OTTAWA, Tuesday, November 18, 1997

The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:35 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, this is the first of a series of hearings, which will take place over the next three days and when Parliament returns after the Christmas break, on the subject of institutional investors.

You will recall that this issue arose when we were holding hearings approximately one year ago on the corporate governance provisions which should apply to the Canada Business Corporations Act. Issues about the role of institutional investors in the Canadian economy in general, their accountability procedures and the impact they had on the companies in which they invested were raised by a number of the witnesses. As a result, the committee decided -- with the active encouragement of a number of senior executives in Canada, non-executive chairmen of the board of major corporations and some large pension funds -- to undertake a study designed to look at the various issues related to the role of institutional investors, their governance practices internally, and their impact on the governance of the firms in which they invest.

We begin today with three experts who will give us an overview of the issues we ought to be exploring with future witnesses.

Please proceed.

Mr. Jeffrey G. MacIntosh, Faculty of Law, University of Toronto: Honourable senators, I am pleased to be here this morning to present my views to you. These hearings will explore two not uncomplicated issues -- the involvement of institutional investors in corporate governance, as well as the governance of institutions themselves.

Let me begin by telling you what a noted corporate law scholar named Theodore Geisel wrote about these problems many years ago. He said:

Oh, the jobs people work at! Out west, near Hawtch-Hawtch, there's a Hawtch-Hawtcher-Bee-Watcher. His job is to watch... to keep both his eyes on the lazy town bee. A bee that is watched will work harder, you see.

Well... he watched and he watched. But, in spite of his watch, that bee didn't work any harder. Not mawtch.

So then somebody said, "Our old bee-watching man just isn't bee-watching as hard as he can. He ought to be watched by another Hawtch-Hawtcher. The thing that we need is a Bee-Watcher-Watcher."

Well... the Bee-Watcher-Watcher watched the Bee-Watcher. He didn't watch well. So another Hawtch-Hawtcher had to come in as a Watch-Watcher-Watcher! And today all the Hawtchers who live in Hawtch-Hawtch are watching on Watch-Watcher-Watchering-Watch, Watch-Watching the Watcher who's watching that bee. You're not a Hawtch-Hawtcher. You're lucky, you see!

You may have guessed, of course, that Theodore Geisel is also known at Dr. Seuss. I think Dr. Seuss's passage nicely encapsulates the issues that we have to deal with today.

Senators, you are Hawtch-Hawtchers. Actually, by my account, you are Watch-Watchers, which is to say that the town bee, hopefully not too lazy, is Canadian corporations, and the bee watchers are Canadian institutions. I suppose the Watch-Watcher-Watchers are the people who benefit from the institutions, and I guess the committee is one level above that.

Now that I have thoroughly confused everyone, let me start to make some sense about Canadian institutional investors.

First, I wish to address the issue of institutional investors and corporate governance. The threshold question is: Do we want institutional investors to be involved at all in the question of corporate governance? I think many corporate managers would tell you that the answer is no, that they do not want institutional investors playing a role in corporate governance. The corporate managers will tell you that those particular watchers know nothing about what it is that bees do, and they want the bees to do some very silly things.

The evidence, in fact, is to the contrary. Institutional investors do have a useful role to play in supervising Canadian corporations. To support this view, we have both theory and evidence.

On the theoretical side, we would expect institutional investors to be better overseers than retail investors, simply because they have much larger interests at stake and, therefore, are likely to take a much keener interest in who is running the corporations in which they have invested.

On the empirical side, there is a lot of support for the view that the involvement of institutional investors does indeed better corporate performance. For example, the fund in the United States that has been most active in corporate governance is CALPERS, the California Public Employee Retirement System. I would like to refer to one study done on CALPERS.

They picked 10 of the worst performers in their portfolio every year. After they became involved in straightening things out at those 10 companies, performance improved over the next few years in the order of approximately 50 per cent; that is, an abnormal return over the market of 50 per cent. So if you had invested in those firms in which CALPERS became involved, you would have done extraordinarily well. The corporate governance program of CALPERS seems to be very successful.

I, along with an economist, did a study on Canadian institutions. We found that where there was high institutional ownership, there tended to be a higher return on assets and equity. There is plenty of other empirical evidence, which I will not take the time to discuss now but which might come out during questioning.

There is much anecdotal evidence that institutions have made a positive difference in corporate governance in Canada, beginning in approximately 1986 with the recapitalization of Crownx, where institutional investors stepped in to oppose a dual class recapitalization and actually succeeded in getting the corporation to abandon its proposal, as well as the Canadian Tire transaction, also in 1986-1987, up to the present where hardly a week goes by without a newspaper story about how some institutional investor or group of institutional investors has made a difference in corporate governance somewhere, whether in relation to a poison pill, an executive compensation plan, or some such thing.

There is much evidence now that institutional investors do good things in corporate governance and that we ought to be encouraging them to do this.

What kind of role does this leave for this committee? It strikes me that there are various legal restraints that make institutional investors somewhat less active than they might be. I will refer to three legal restraints, which will sound familiar to senators since these are things that were touched on a year ago in the broader corporate governance proceedings. I will mention them because they do impact on the way institutional investors carry out their business.

One is the absence of confidential voting, a key issue in the sense that many institutions are not active in corporate governance because of conflicts of interest. Banks and life insurance companies are virtually completely absent from matters of corporate governance. It has been the pension funds that have been active, in particular the public pension funds. The banks are not big equity holders, but the life insurance companies are. One of the reasons for this inactivity in corporate governance is conflict of interest; that is, they do not want to be involved in matters of governance where the result might be to get on the wrong side of people who are either current clients or potential clients, corporations for whom the company might be writing insurance policies or might wish to write insurance policies. This conflict-of-interest problem is absolutely essential to the role of institutional investors in Canadian capital markets.

If confidential voting were instituted, management would not be able to punish them for voting in a way that appeared uncongenial to management.

Another legal restraint relates to proxy rules. This matter has been under discussion in Canada for a few years and would ensure that shareholders can engage in effective, informal communications without triggering the requirement for a distance proxy circular.

The last matter is the takeover bid threshold, which is now, in the Canada Business Corporations Act, 10 per cent. It ought to be raised to at least 20 per cent, to conform to the provincial legislation.

I will make a few very brief remarks about the governance of institutions, focusing on the governance of pension funds. That is perhaps the most pressing governance problem that we face in the institutional arena.

Obviously, pension fund governance is an important issue. With the Canada Pension Plan beginning to fray and tatter around the edges, it is obviously important that private pension plans be there to provide a safety net to Canadians when they retire.

The problem of pension governance is, in many ways, more difficult than the problem of corporate governance, in the sense that you do not have the same market controls that are controlling the activity of managers. For example, if a corporate management team performs badly, there might be a hostile takeover in which the managers are displaced from without and a new management team put in. You simply do not have the same kind of market mechanism in the case of a badly performing pension; nor do you have the kind of direct oversight by the people who are the beneficial owners of pensions that you have in a private corporation where shareholders can directly replace the managers. The problem of governance is a very difficult nut to crack.

The committee may find it beneficial to focus on the issue of who ought to control the board of the pension fund. This is one of the crucial issues. One ought to be asking: Who is in a position most analogous to the shareholders of a private corporation? Who has the interest most analogous to the residual claim in a corporation? There are good reasons for believing that those who hold the claim that corresponds most closely to the residual claim have the best incentives to run the pension fund. In a defined benefit plan, it is the corporation itself. The corporation, as sponsor, has to make up any shortfall in the defined benefit plan and typically these days, at least in newer plans, will have made arrangements to capture the surplus, if any, and therefore looks a lot more like the residual taker than the beneficiaries of the plan.

However, in a defined contribution plan, it is the beneficiaries of the plan who are the residual risk-takers. Therefore, they ought perhaps to take a much more active role in the governance of the fund, subject to the consideration that employees need a considerable amount of expert guidance in setting up the structure of a defined contribution plan so that employees will be knowledgeable enough to select options that suit their risk preferences and time horizons.

I will stop there. I am sure there are many questions that will arise as a result of my remarks. I will let my confreres get in on the action.

The Chairman: Thank you, Professor MacIntosh.

Dr. Por, would you like to proceed.

Mr. John Por, President, Cortex Applied Research Inc.: I wish to restrict my comments to the governance of large public sector pension funds, for a number of reasons. One of those is that these funds are huge and the degree of potential influence they can exert over the Canadian economy is enormous. To give you some scope of this influence, in 1996 in Canada the 15 largest public sector pension funds had joint assets of over $150 billion. One should compare this with the $50 billion of the 15 largest private sector pension funds. That is probably now about 30 per cent more due to market movement.

The Chairman: So the 15 largest public-sector funds are collectively three times larger than the corresponding number of private-sector funds.

Mr. Por: That is a good way of putting it. Another way of putting it is to say that while the private-sector funds are not growing other than by asset growth, public-sector funds are growing through a tremendous amount of contribution as well.

While the private-sector pension funds come under managerial oversight of boards and executives accustomed to the scope of decisions involved, public-sector pension funds are usually governed by boards whose members may only infrequently encounter decisions of a similar nature in their day jobs. People sitting on the investment committees of private-sector funds regularly make big financial decisions, while the board members of public-sector pension funds very infrequently do so.

The difficulty of this task is compounded by the fact that the principles of group decision-making, delegation, governance, workings of effective financial reporting and monitoring systems, the broad nature of capital markets, the risks involved in asset-liability mismatch, et cetera, are not concepts which can be easily acquired through general readings.

The third comment is that while public-sector plans were originally set up 25 or 30 years ago to provide oversight of pension administration, they have gradually evolved into organizations which invest a significant portion of Canada's capital and, as a matter of fact, of North America's capital. It is important to note that since they were set up by legislation, no significant attempts were made to make them adapt to their new role. In order to change, legislation must be changed and that is not an easy feat.

These funds, at the same time, are under tremendous pressure to satisfy the understandable but specific and usually not impartial interests of a very diverse stakeholder group without any agreed-upon, objective yardsticks of success. Many articles have been written and many theories abound concerning how to judge the success of large public-sector pension funds. The debate is still ongoing without any specific resolution to that issue.

Who are the stakeholders? They are the membership who always have an interest in low contribution and ever-improving benefits; the unions -- more control, better pensions, lower contribution; employer groups -- more influence, lower contribution; governments -- potential source of revenues; the fund's own staff -- higher income, career growth. Then there are the service providers, the money managers, the actuaries, the consultants, the lawyers, the accountants, the custodians, for whom these funds provide a very decent source of income.

Private-sector funds must also consider competing interests. Usually these interests are just not sitting right there on the board and participating directly in the decision-making.

We have found that pension boards, once established, have no clear-cut transfer and selection processes to ensure that their members are experienced, knowledgeable and fit for fiduciary duties. Usually, appointments are effected by the stakeholder groups, which could be governments, employers, unions. Hence, the selection process is heavily influenced by agendas outside the paradigm of good governance and fiduciary duties. A good case could be made that a cycle of weak boards begetting weaker boards and even weaker executive staff may set in, due to the nature of the defined benefit plans, and the public purse will suffer.

In light of the above issues, the governance practices, at least in our view, of large public-sector pensions should be examined with the purpose of building guidelines for improvements. Here are some questions to consider.

How can we ensure that accountability exists? The board may fail to effectively govern and the general taxpaying public is penalized through increased taxes. Governments at least must be elected periodically. Pension boards -- one can say this with some trepidation -- are not really accountable to anyone, once they are set in.

How can boards ensure that a significant number of their members have the necessary scope, experience, knowledge and, essentially, the time to oversee the complex operations involved, which would include investments management, information systems, administration, communications, risk management, et cetera?

What are the mechanisms in place and what kind of mechanisms can one put in place to keep constituency pressure from dominating fiduciary considerations?

Given that the boards appoint the chief executive officer of a pension fund and that board members are appointed by their constituencies, how can the independence of the CEO be maintained in dealing with constituency pressures? Where is the clear delineation of duties between board and executive staff? How can we ensure that boards are not micro-managing the business?

What are the measures of success of a public-sector pension plan and fund? What mechanisms are in place to ensure that pension funds follow the best governance practices -- which are dubious because who knows what the best practices are? How do boards ensure that, as an entity, they possess and will continue to possess direct knowledge and information for discharging their fiduciary duties?

Mr. Keith P. Ambachtsheer, President of Keith P. Ambachtsheer & Associates Inc.: Honourable senators, I also have no poem with which to begin. In a moment of reflection, my chosen word would be "convergence." I testified to the House of Commons Finance Committee yesterday morning on Bill C-2. The session yesterday morning specifically focused on the CPP Investment Board.

I have taken the liberty of simply changing the name at the top of my presentation; essentially, the words are the same. I do that partly as a manifestation of the thought that we do live in a world of convergence and some of these issues are coming together in interesting ways with the general topic of governance and the specific meaty issues in front of the House of Commons.

I have been involved in advising large pension systems around the world on issues of governance, finance and investments for some 20 years now. One of my more interesting experiences over the years was to work with the CPP Working Committee on Investment Policy to put together some thoughts on the structure of the CPP Investment Board.

It is in that context that I will share some opening thoughts with you and we will see where it takes us.

Just as the three things which matter most in real estate are "location, location, location," so the three things which matter most in the management of large retirement systems are "governance, governance, governance."

Second, this is no longer just an opinion. A major study which we have just completed involved 79 major U.S. and Canadian pension funds and one Dutch pension fund. We were able to find a statistically significant link between organizational performance and organizational design. Interestingly, and more specifically, we found the most important driver of organizational performance, based on a standardized metric over the last few years, to be the quality of the board of governing fiduciaries.

As additional background, this study was sponsored by eight major pension funds around the world, two of which were Canadian -- OMERS and the Ontario Teachers' Federation. There were three large U.S. retirement systems -- CALPERS, as mentioned by Professor MacIntosh, Wisconsin and Florida. There were two major U.S. corporate funds, AT&T and IBM; and finally, the big Dutch civil service pension fund. The aggregate value of these eight funds is over $500 billion. We can talk more about the analysis later if you would like to pursue that.

This very new research actually has not yet been published. One of the businesses with which I am involved develops these standardized metrics with respect to organizational performance. That is much more difficult to do, generally, in the publicly traded corporate world.

They are still struggling with a measure called EVA, something which does develop a standardized metric economic value added. A firm with which I am associated developed a measure called RANVAD, risk adjusted net value added, and the organizational performance measure of which I spoke is that particular metric.

Before this research, we had already established that there was a statistically significant relationship between pension fund performance and size -- assets under management. That relationship was positive. In other words, we find that, on average, bigger pension funds have better performance than smaller pension funds. Therein lies an important dimension we should all keep in mind. Obviously the question is: Why should this be so?

One direct answer is simply economies of scale. The fund management business is a business where economies of scale are tremendously important. You can visualize that. As the assets increase, the costs of management do not increase at the same rate. Unit costs decrease significantly for large funds.

Another factor which may not be quite as obvious relates to the ability of large pension funds to organize themselves as businesses, complete with boards of governing fiduciaries and expert management teams which are given clear mandates as to how to run the business and what kind of goals to achieve. They in turn can hire a staff that is expert in their respective fields and can carry out their responsibility.

A subtle idea in this institutional investing business is the question that was actually the name of a report which came out of the Ontario public sector task force in 1987 titled In Whose Interest? A tremendously important thing to keep in mind with respect to retirement systems is that they need governance mechanisms where there is a clear mandate to act in the best interest of the stakeholders of that retirement system as opposed to the interest of various kinds of suppliers, the investment dealers, and the investment management community, all of which are anxious to offer services to retirement systems. It is tremendously important to create what economists would call informational symmetry between buyers and sellers. You need buyers that have the same amount of knowledge about their business and how financial markets work as do the sellers. That is the more subtle reason why we find that larger pension funds have better organizational performance than smaller pension funds.

The organizational design quality factor and the size factor are obviously highly material for the CPP Investment Board, which will become a large institutional investor within six or seven years. The latest number I have seen is somewhere between $75 billion to $100 billion in terms of assets, which does not make it any larger than Caisse de dépôt et placement du Québec or Ontario Teachers', which is currently at $50 billion. It is of that order of magnitude. You cannot think about the system strictly in domestic terms. You must think about the system in a global context, where pension funds of $50 billion to $100 billion are not at all uncommon.

The other point I would make is that this is now a green light on moving ahead with the public service retirement system in Ottawa, which has been basically managed on a cash-flow basis where the net positive cash-flow purchases non-marketable, government debentures which then accumulate. That whole system is now in the process of reorganizing itself as yet another major stand-alone retirement system, with details to follow -- they have not been worked out. That is another $60-billion system which is potentially not that far away from playing a market-type role in our financial markets.

To develop a language about the different kinds of players involved with pension funds, there are governing fiduciaries, which are effectively the board. There are managing fiduciaries, which are generally the people accountable for managing the business; and then there are operating fiduciaries, people to whom individual tasks have been delegated.

The point that I would make -- and this is certainly relevant with respect to the CPP Investment Board which is in the process of being formulated -- is that how well that system performs will be largely determined by the quality of the 12 appointed people, with the delegated power to create a management structure to create a vision for that organization and to report out to Canadians as to how well that system is performing.

The final point that I would make -- and people who know me know that I do not miss any chance to make this point. I saw this 10 years ago, but most people now recognize that we live in a global world with global financial markets. With the 20-per-cent rule, trying to manage the proportion of assets that Canadian funds must keep investing in Canada is becoming increasingly inappropriate. This is a good forum to place that view. I believe -- and hopefully Mr. Martin will agree -- that we must be close to letting that rule go so that Canadian pension funds do not operate under any handicap. We live in a global world, and we must accept that reality.

The Chairman: Thank you very much.

I wish to ask the first question. You have talked about institutional investors and pension funds and the difference between public- and private-sector financial pension funds. There are many individual Canadians who are investing their own money in the market, either through mutual funds or on their own. Should those individual investors care about the outcome of this kind of study or the governance of institutional investors, or should the only people who really care about this be people who run major corporations in which funds are invested and the institutional investors themselves?

Mr. Ambachtsheer: I was involved in the creation -- and it was just released last Thursday -- of a paper by ACPM, the Association of Canadian Pension Management, which looks at Canada's national retirement income system as a whole. It talks about three pillars: minimum income support; CPP/QPP; and the voluntary sector, which then divides into employment-based pension plans and a whole myriad of RRSP-based investing opportunities that are group RRSPs or in many cases individuals investing into the financial market through the mutual fund industry.

We point out in this paper that we should all have a concern about the current system relating to this idea of unbalanced information between buyers and sellers. An interesting statistic was published a few weeks ago in a Canadian business magazine. A survey was done whereby 2,000 Canadians were asked whether they knew what level of mutual fund fees they were paying. An astounding 45 per cent of them did not know they were paying any fees at all. We argue in this ACPN paper that is a major informational problem, because while the markets earn 20 per cent per year, you can pay 2 per cent in fees and it does not matter very much. However, in the future world, when we look realistically at single digits, 7 or 8 per cent in the long term, nominal returns, the rule in pension economics is that for every 1 per cent of return you give up, you loose 20 per cent of your final pension. Consider a 2 per cent fee versus that of the Ontario Teachers' Federation which runs at one-tenth of 1 per cent. The differential in fees is huge, and that is just not generally known. That factor is important in terms of understanding the third pillar and the economics of it.

Mr. MacIntosh: My comment is of a slightly different nature.

Institutional investors play a vital role, as I have suggested, in making sure that corporate managers manage in a disciplined kind of way. That benefits not only institutional investors but also small, retail investors, especially as markets become more efficient and it becomes much more difficult for a small, retail investor, or indeed institutional investors, to beat the market on the basis of information they might find in the newspaper in the morning.

Institutional investors protect not only their interests but also the interests of other investors who, if you will, are free riders, in the sense that if corporations are generally better run in our economy, then all investors will benefit from that.

In addition, institutional investors now do the bulk of the trading in Canadian capital markets.

The pricing efficiency of the portion of the market in which you find active institutional investors is a lot greater than the pricing efficiency in that segment of the market in which you find only retail investors.

Here is another case in which retail traders are, in a sense, free riders. That is, institutional investors, by virtue of protecting their own interests and engaging in a lot of trading and making sure that stock prices reflect all currently publicly available information, are doing a favour to anyone who trades in the securities markets.

Mr. Por: I want to add to what Mr. Ambachtsheer said. If, for whatever reason, these large public-sector public pension funds do not perform as well as they could or should, the tax-paying public will have to cough up the money because the actual benefits are defined. That is the nature of defined benefit pension plans. It is not only the private-sector investor who should be eagerly looking at this issue. All of us who are, one way or another, taxpayers in this country should be looking at it because we must pay the price of the difference.

Senator Kolber: First, I, too, am a fan of Dr. Seuss and I enjoyed what you said.

On the question of confidentiality, are you talking about when you send in your proxy?

Mr. MacIntosh: The idea that lies behind confidential voting is that management at no time gets to see how people are voting; management never gets to see the proxies. Most voting is, of course, done by proxy. My understanding now is that managements are able to figure out who votes in which way.

If we design mechanisms to prevent them from doing that and protect the confidentiality of institutions or other investors voting one way or another, then that might make some inroads into this problem of conflicts of interest.

Senator Kolber: I do not see how you can do that, but that is an idea.

There seems to be a wide range of subjects that we are talking about here. First, there is the question of institutional investors vis-à-vis corporations. How does that manifest itself in any sort of legislation or regulating body? Why should an institutional investor be treated differently from any other shareholder who wants to make himself heard? I do not quite understand what we are getting at here.

Mr. MacIntosh: I was not arguing that institutional investors should be treated differently. In talking, for example, about the shape of the proxy rules, the argument is that the proxy rules ought to be crafted in such a way as to make informal communications between investors feasible without having to go through the whole apparatus of putting together a distance proxy circular, and so on. I would certainly extend that to any other shareholder. I was not trying to distinguish between institutional and other shareholders.

Senator Kolber: From a governmental point of view, what would you do that is not already done?

Mr. MacIntosh: Perhaps I should give you a copy of a paper that I wrote and brought with me. It examines the various legal aspects -- both provincial and federal -- that impinge on the activities of institutions that want to get involved in corporate governance. There are approximately 10 or 15 different legal dimensions to the problem. I talked today only about three of them.

There are various legal barriers that tend to have an impact on the activity of institutions getting involved in corporate governance, such as the proxy rules or the insider-trading rules. I do not want to launch into a long discussion of all those problems but perhaps I should give the committee a copy of this paper.

Senator Kolber: I was fascinated that you brought up the question of the efficacy of large pension funds as opposed to small pension funds.

I have been involved in my lifetime with some large pension funds, such as Dupont, Seagram, TD Bank, and so on, and they are all run in different ways. I am not sure we could do anything about it. The problem with small pension funds is they just cannot afford to hire the best managers as in-house managers.

When you look at the great successes of running money, they have been by the people who have given them out to managers. I think the idea that a pension fund has to have its own staff all the time is probably wrong.

Mr. Ambachtsheer: If you look at the issue from an organizational design point of view, I think it is a reasonable proposition to say that any business that is going to operate to achieve certain goals needs to have proper governance and an organizational design structure to achieve those goals.

By the way, my cut-off point between large and small is at about $1 billion. To me, anything below $1 billion is small. The reason I say that is, as per your point, below that number it becomes difficult to support the economic proposition that that smaller fund has a management team dedicated to achieving positive risk adjusted net value added in the kind of financial markets in which they must operate. There is a long-standing rule in game theory which states that you do not play games you cannot win. I would argue that most funds under $1 billion should follow the passive management route.

Senator Kolber: I wish to ask you a question on fees. You said that the Ontario Teachers' pension fund only pays one-tenth of 1 per cent in fees.

Mr. Por: It is the cost, not necessarily the fees.

Mr. Ambachtsheer: It is the all-in costs. Their money is managed 90 per cent internally and 10 per cent externally. When I quote 10 basis points, it is the aggregation of all of the costs, both internal and external.

The Chairman: That is not trading costs. That is operating costs of the fund itself. Salary is an overhead.

Mr. Ambachtsheer: That is right. The risk adjusted net value added metric would be net of transaction costs, and the fees and internal costs would be specified separately.

Senator Kolber: The last point I want to make is a hearty endorsement of your globalization theory. I think this 20-per-cent rule is idiotic. It is absolutely imperative that it be changed. I do not know how a plan such as CPP, with $100 billion worth of assets, can be run if it is restricted to the Canadian market. It will compound our problems. I hope the committee will see fit to advise the government that this is something that should be rectified.

The Chairman: For the record, I should point out that at least twice in the last four or five years, including about one year ago, this committee unanimously urged the government to get rid of the 20-per-cent rule, for the same reasons that Senator Kolber has just mentioned.

Mr. MacIntosh: I would like to support Senator Kolber's point. Canada is about 3 per cent of the world financial market. Many Canadians do not understand that by forcing Canadian pension funds to invest in Canada, we are forcing people who have pensions to receive a sub-optimal risk-return trade-off. Clearly, you can enhance your risk-return trade-off by buying into financial markets. If many Canadians realized that, there would be more pressure on the government to get rid of the 20-per-cent limit.

Senator Angus: Welcome to the committee and thank you for setting the stage for what I think is already becoming an interesting discussion.

For some time, we have been faced with these challenges about corporate governance. Your poetry at the outset was interesting because our challenge is to watch the clock-watching clock watchers, and it is not always easy. The study which this committee did on corporate governance focused on the basic governance rules of Canadian public corporations. Therefore, my question is fairly elementary, and I should like to have any one or all of you elaborate on it.

Professor MacIntosh, you seem to be saying that the governance of publicly traded Canadian corporations can be enhanced by the role of institutional investors, if you will, whereas in our earlier deliberations we heard that this was rather a difficult area. I submit that it is the smaller retail investor, perhaps, who needs the protection more than the big boys, since he is often disadvantaged. That can be by privileged information, the innuendo of briefings that go on, similar to briefings that go on with analysts which are, perhaps, more intimate, or lunch with the president of the institution or the CEO of the corporation.

We decided to have this fact-finding study to see what kind of governance the institutions themselves should have, given that there seemed to be a difference. You all seem to agree that there is need for some strong governance rules for institutional investors. Could you delineate the differences, if there are any in your minds, between the institutional investor and the publicly traded corporation?

Mr. Por: I tried to highlight some of these differences in my opening remarks. I see two or three major differences, which is why I have come to believe, after five years of haggling, that, quite frankly, corporate governance may not be as big an issue as people, including myself, originally thought in the late 1980s and early 1990s. First, to a fairly large degree, we can read every day in the newspapers about how bad a company is doing. Therefore, eventually, after three to five years, the directors, whether they like it or not -- and usually they do not -- are forced to do something because the results are not sufficient.

If something happens, we know about it fast. However, with a large public-sector pension fund, on which I am concentrating my efforts, you can go on for years without actually knowing how it is doing. One of the ongoing debates in the industry is that something can be set up and start to work and you will not know before 15 or 20 years whether or not it is working out. And that is the other problem -- namely, that public-sector pension funds are not working in what we would call a market economy, per se. Therefore, one has to find measures -- and Mr. Ambachtsheer is working on this diligently -- we can use in lieu of the market which will tell us what is going on.

Third, in terms of publicly traded corporations, the rules for selecting directors are reasonably clear. There are generally accepted criteria with regard to who should serve as a director. We can get into a lot of arguments, which happened in the last couple of years, concerning who should serve as directors. There is a reasonable consensus that these are the people we should have.

In the public-sector pension funds, we came up with the notion that good governance is such that we invite the people who are affected by these decisions. These people could be employer groups, from the government, union groups, et cetera. From there on, there is no mechanism to pick these people, other than a very political process. I must suggest that in Canada we have less of a problem than in the U.S. My company worked with one of the largest U.S. pension funds. It is even worse there.

Once the governance process is not working, there is nothing much to date that you can do. We asked the question: If you feel that your representative on these boards is not doing the job well, or another representative of another constituency group is not doing the job well, then what can you do? The answer is: Practically nothing.

The selection of board members, the definition of what kind of knowledge should be there and non-performance identification, which is almost non-existent in large public-sector pension funds, are factors to be considered. It is a very different kind of environment in which to make governance decisions.

Mr. MacIntosh: I agree with everything that my friend John Por has said. However, I should like to put it in legal-academic terms.

The current thinking about corporations is that there are a variety of market and legal controls which constrain managers. Typically, we talk about four different kinds of market controls. I mentioned one, which is the hostile takeover. You cannot have that in a pension fund.

You also talked about the constraints put in place by the product market. That is, corporations sell products; if the product fails, the corporation fails and the managers are out of work. Again, that is not in place with a pension fund.

We talked about a market for managers in which managers compete for jobs either within the corporation or outside the corporation. That market does not really work in the case of pension funds.

Finally, corporations are subject to a cost of capital every time they go into a capital market. Again, pension funds are not.

You basically take away those four market controls. You then look at the legal side and ask: What are the controls on the legal side? There are fiduciary duties and duties of care and skill. If you look at the pension benefits legislation in Ontario, you will find that there are these duties that apply to trustees, just as they apply to corporate fiduciaries. However, the question here is: Who will bell the cat?

In the context of the corporation, you may have an institution with a large stake which is willing, if push comes to shove, to sue management. Beneficiaries of pension funds simply do not have the same incentive. Each beneficiary has a small interest. It becomes a question of who will pay the costs of the action, which may be considerable. On paper, the duties look very much the same, but they do not mean the same thing in terms of enforcement.

Finally, there is the question of oversight. In direct oversight in a corporation, shareholders elect directors. Mr. Por mentioned in the context of pension funds that that does not happen.

If you look at the whole array of controls that exist to discipline corporate managers, you take away almost all of them in the case of pension funds. That is why I say that pension fund governance is a much more difficult problem than corporate governance.

Senator Angus: First, I thank you both for those answers. What I understand you to be saying is that there are inherent checks and balances which naturally pertain to public companies trading on the stock exchange. Therefore, the need for some stricter accountability and controls on the institutional investor is quite great.

I am assuming you more or less agree with that summary. If you do not agree, then I hope you will say so.

Largely, you have confined your comments to the pension funds, be they private or public. I am left wondering about investment counsellors. Do you consider them to be institutional investors? Small mutual funds, some open-ended and some closed, seem not to be interested at all in even discussing this subject.

Could you comment on that, please? As far as I can see, there are no laws which govern them.

Mr. Ambachtsheer: My friends in Australia use the word "contestability" in relation to this aspect. The whole notion of contestability is where you have fairly natural monopolies, in the sense that if you have a retirement system that covers these 200,000 members, it is not like you can start a competing one and get a market kind of outcome. However, you can do some things, such as the notion of how transparency can be simulated and motivation incentives can be created, so that similar outcomes are achieved as in a market kind of environment.

The key to success is benchmarking. Metrics must be developed which truly represent the kinds of outcomes that the stakeholders would value. That is where one must start. If one has no metrics to measure whether the system is doing what it is supposed to be doing, one has nothing.

The interesting thing about the institutional investing field is that there is a tremendous amount of data produced in this field, and that as such, there is an interesting hierarchy that we should remind ourselves of which is that data should become information, should become knowledge, should become wisdom. The challenge in the area of pension funds, the institutional investing area, generally, is exactly that; namely, to turn lots of data into information that truly informs and then creates knowledge about how to do things better.

That process has begun and it needs to continue. There is a long way to go. There is no other answer other than to create contestability for these systems and to simulate some of these disciplines in this area which do not naturally occur because they need to be different from the ones that exist in publicly traded corporations. I believe we can do that.

Senator Kolber: Could we get an example of that?

Senator Angus: Is it possible to have a specific example of your last point on benchmarking and setting up a performance-based hedge or hurdle?

Mr. Ambachtsheer: Let us take a defined benefit pension plan. The idea is that its members are promised a benefit. At any particular point in time, the accrued obligations can be estimated. In other words, on the debt side of that balance sheet, if we put a present value on these future promises, it is, for example, $10 million using today's market rates.

The question on the asset side of that balance sheet is: "If you have $10 billion worth of assets, how do you invest the assets?" You have a couple of basic choices. One is that you can make the assets look as much as you can like the liabilities -- the same duration, the inflation sensitivity, and make them government guaranteed. Then you have what is technically known as an immunized balance sheet.

Senator Angus: Is that like a conservative portfolio?

Mr. Ambachtsheer: Exactly. The business of a pension fund is basically to manage that balance sheet. In that sense, it is not much different than any other business, insurance company or bank that is also trying to manage a balance sheet. The choices are the same. You can try to minimize risk on the balance sheet, but the problem is that that outcome is costly because if you can earn an extra 1 or 2 per cent on the assets, it reduces the cost of the pensions. One can put equity risk on the balance sheet. A typical ratio for pension funds is 60/40 equity debt. That is done to assume that you can earn an equity risk premium which then reduces the cost of the pensions. There is an asset-mixed policy decision. It is a fundamental decision that needs to be monitored.

The other kind of decision is how you implement your asset-mixed policy. You could do it passively, through an index passive-type program. Or you can do it more actively and take what is called active management risk, which is basically to participate in the market, to try to earn additional return, usually at additional cost and additional risk.

If those are the key decisions that are made, you need to measure the outcome of those decisions.

Senator Angus: You need to find a fairly foolproof way to monitor the situation; is that correct?

Mr. Ambachtsheer: The impact of the asset-mixed policy decision and the impact of the implementation strategy is what you must measure.

Mr. Por: There is one thing I should like to add to our previous comments. We may have said that there is an impending disaster and that unless we do something radical... That is not the case. That is the first point.

We are not facing an impending crisis in the management or governance of large public-sector pension funds. We face a future whereby these public-sector pension funds will grow and grow. Eventually, according to our calculations -- even now, they own 50 per cent of the outstanding shares of the largest corporations. They did not know, and the corporations did not know, what to do with that power.

Mr. Ambachtsheer is describing metrics which are available and are continually being refined. Unfortunately -- and I have been working with groups of decision-makers like boards -- this debate is between corporate financial experts, theorists, whatever, and it is a very slow process whereby we could get the boards to actually accept these metrics. Some of them accept these metrics more readily than others.

We find, in working with boards, that in order to follow these metrics, board members must give up significant individual power and they are unwilling to do so.

We are working on a pension fund in California, and we are looking at these metrics. It is easy to say: "We are screwing up. Why do not just do something else; we will not get involved." That is not a realistic answer.

Your task is to find a method -- you have the metrics, which are developed, and the financial theory, which is emerging reasonably clearly -- and get the boards to act upon this wisdom and commit themselves to a learning curve. I am referring to existing boards.

Senator Angus: I wanted to get an answer on my point on investment counsellors because they have so much power.

Senator Kolber: The idea about the omnipotence of a board of directors always comes through to me. As a director of large corporations for about 25 years, I feel that boards of directors, in large corporations, anyhow, are fairly useless.

Mr. Por: That would be a sad commentary of how our system works.

Senator Kolber: I should like to hear from you learned gentlemen, because it seems to be the crux of everything you are talking about. It is something that we have not come close to solving.

In the final analysis, the mandate of a board of directors of a large corporation is nothing more than hiring or firing the CEO. If you could convince me it is more, then I will feel enlightened, believe me.

Mr. MacIntosh: Your question goes back to the Berle and Means theory of 1932 which is that the management of public corporations were, in fact, self-perpetuating entities because shareholders either threw the proxy material in the garbage or just endorsed management's nominees.

That view stood unchallenged for about 50 years.

Senator Kolber: We are now at 1982.

Mr. MacIntosh: About that time, or a little later, institutional investors started to become active and financial markets started to get a bit more efficient. Scholars were beginning to wake up to the view that there were these other controls on managerial behaviour that we talked about before.

Nonetheless, many corporate scholars have suggested that outside directors, independent directors, who are supposed to play an important oversight role, are very often not terribly independent because they have been historically nominated by the CEO. They have office at the pleasure of the CEO. If they disagree or ask difficult questions, they will not stand for election next time around.

There are many who would take a sceptical view of what a board of a large public corporation is capable of doing.

On the other hand, with enhanced oversight from investors, like institutional investors, in particular, we are getting more oversight than was ever the case before. Hence, large boards of public corporations are better policed, perhaps not well-policed at this point in time, but better policed than they once were.

Mr. Ambachtsheer: If I can relate back to the study of 80 pension funds, the organizational design was based on CEO or equivalent ratings in the pension fund about certain statements. One that correlated most highly with organizational performance was the clarity of the delegation between the board role and the management role. This is directly related to what Mr. Por was saying earlier.

In a lot of pension funds, you get micro-management at the board level where clarity requires delegation to a CEO. They might say, "Now that we are clear about the mission, the vision and what we are attempting to achieve, just do it." There is a lot of fuzziness in many pension funds about what management decisions are effectively being made by committees. That is not an effective way to manage a business, and it shows up in the results.

Mr. Por: If we believe that the board's role is only to wait five, six or ten years until the CEO proves to be incompetent to run a corporation, then the board's role of replacing the CEO or not is a blunt instrument. By the time you do that, unfortunately, the value-added component of that corporation is lost.

Boards follow a number of rules today. First, they must accept a strategic plan developed by the management team. It is up to the board to decide to what degree they want to get into the details of that plan and whether it makes sense.

They cannot avoid dealing with institutional investor pressures because these people are sitting in large public-sector and non-public-sector pension funds -- money managers aside -- analyzing the hell out of companies. They must respond to that.

If a board of directors wishes to take its role seriously, it could do so, but it requires a different mindset, which is developing. If we had had this conversation in 1991, it would have been in a completely different context. Most of the directors I know are seriously considering what their role and responsibilities should be, who they are, and what they should do about it. In the late 1980s, I do not think this question was ever asked.

Being the member of a board of directors is an onerous task. It will take 15 years to develop how these practices will actually affect the governance of these corporations. There is no question that these forces are in place.

In the North American system, where capitalism, capital markets and freedom of the press are much stronger than in Europe, these issues are coming to the forefront much earlier. In Germany, strong representation from boards came about in 1936-37 when freedom of the press and capital markets were not as strong as they are today in the U.S. Therefore, they had to create an effective instrument, which was the supervisory board.

Senator Angus: Perhaps I can get to the point I am seeking in another way with respect to investment counsellors, mutual funds and other institutional investors, besides the big public pension funds you are concentrating on.

The manager of the CN pension fund appeared before us about one-and-a-half years ago. He listed, in descending order, approximately 14 or 15 cardinal points that he watches for amongst the management or the governance of a publicly traded company. A threshold of alarm bells ring for him. Could you suggest a similar list of points that an investor should watch out for, in terms of institutional investors? Where are the soft spots and the warning bells starting to ring? Again, I focus more on the investment counsellor and the mutual fund where you see widows and estates. Maybe the original benefactor is a sophisticated investor, but the widow, or the family, is left with these large pools of capital. They fall into the hands of these individuals. They are not in a position to know. One of our missions here is to delineate a list of signals.

Mr. Ambachtsheer: The key thing that I would look for in hiring a third party or outside investment counsellor would be the alignment of economic interests. With respect to large public funds, they are directly accountable to a set of stakeholders. They are looking after their interests.

Once you go to a third party, whether it is investment counselling or most of the mutual funds, there is an interesting dichotomy of economic interest, in the sense that these businesses are owned by other people who are trying to maximize their own bottom lines. They are in the business of running that business, and they are looking at revenues, less costs, equalling their profits. There is a question as to whether there is a clarity of economic interest between serving the customers well and how they enhance their own bottom lines.

In theory, the market should work these things out. But unfortunately, this is an area of great informational asymmetry where the sellers know a lot more about the nature of the product and what the services are than the buyers generally. Economics tell us that when you have informational asymmetry, generally the outcome is low-quality products at too high a price. That is one of the challenges -- namely, how do you deal with great informational asymmetry typically between the buyers of investment management services and the sellers of investment? I do not have an obvious answer to that, other than raising the general level of clarity about what the product is producing and a level of understanding of capital market efficiency. We have a high degree of informational efficiency, and chasing these money managers to do better is very difficult.

Mr. Por: One thing people tend to forget, even corporate clients who are CFOs and treasurers, is that the pension fund business is completely different than the mutual fund business, or money managers for that matter. Money managers are there to manage money and attract further money in order to enhance their fees. That is their business. Pension funds are there to fund reasonably understandable promises in the long term. They could elect to be conservative and immunize the portfolio, or they could mismatch their portfolios according to their abilities. At the end of the day, mutual funds or money managers will always try to attract more money.

How do they do that? They never emphasize the money you have to pay for the service. They always emphasize short-term results. You never see, for example, that over the last 15 years they have beaten the TSE by 15 basis points. That information is not sexy.

At the end of the day, the answer is a thorough education. I am always surprised by how little these facts are known by people in corporate finance and by the general public. Unfortunately, this is not a good story. Whenever you read an article about mutual fund performance, you are always dealing with the stars and the dogs. You are never dealing with the efficiency of the markets and the fact that it is horrendously difficult to beat them.

In my view, even the media has a lot of catching up to do. They are misleading the public, telling them they should look for the stars to get them to Nirvana.

Senator Angus: It is too late when you get to that.

Mr. MacIntosh: I agree absolutely.

If I were a beneficiary of a pension fund, or investing money in the market in any capacity, I would want the people investing my money to know a few basic things about capital markets. One is that Canadian capital markets are pretty much efficient, at least in the larger firms that institutions tend to invest in if not in the small-firm sector, and that means that it is very difficult to beat the market on the basis of fundamental information; that is, reading articles in the newspaper and looking at balance sheets and income statements. It is very tough because in an efficient market public prices reflect all publicly available information.

That is very important datum reflecting on the value of active management. Active management, as Mr. Ambachtsheer said earlier, seeks to sell over-valued stocks and buy undervalued stocks. There is a tremendous amount of evidence that that is very tough to do. I would want someone investing my money to understand these basics about efficient markets.

Also important is the value of portfolio diversification. It sounds trite, but economists will tell you that your best risk-return trade-off is achieved when you buy something called the market portfolio, which is all financial assets that are available in the proportion that their value bears to the total value of the whole market. You want a wide range of asset classes to achieve this best risk-return trade-off. I am not sure that many retail investors know as much about diversification as they ought to.

Finally, indexing strategies, whether you are a retail investor or an institutional investor, are extremely low-cost and very effective strategies. You cannot underperform the market. You will never outperform it, but you have a very low-cost strategy. If you buy an index like the TSE 300, away you go. It does not matter how big or small the fund is. It a very low-cost and effective way to go.

Senator Austin: I should like to thank you, Mr. Chairman, for organizing a fascinating morning with remarkable expertise.

I have a number of questions scattered around the topic. First, I should like to go to the question of the 20-per-cent limitation. What was the original public policy, as you understood it, that imposed the original limitation which became 20 per cent?

Mr. Ambachtsheer: The earliest evidence that I was able to find was from a gentlemen called Edgar Benson in a 1971 budget. At that time, it was the 10-per-cent rule. Some of us spent many years labouring to get it from 10 per cent to 20 per cent.

The original motivation was a perception that Canada was a huge capital importer, that we had not a very good and sturdy financial infrastructure in this country and, therefore, protection was required. The way the story is told is that pension funds and investors are getting this tax break and therefore they ought to put something back. They invest in Canada, which creates jobs, et cetera. That is the myth you are dealing with.

Senator Austin: What is the reality today as you see it?

Mr. Ambachtsheer: Whether you buy this capital-importing argument or not, it is certainly gone. If you look at capital flows today, you see huge flows going out and coming in. It is not an issue any more. A huge change is the fiscal position of the federal and provincial governments. Five years ago, it could be said that we had to borrow $50 billion every year. That is not true any more.

If you look at the relative prices of the Canada 30-year bond and the 30-year Treasury bond, you will see that the yield on the Canadian bond is now lower than on the U.S. bond. Whatever conditions may have existed in the past, they are gone.

The real shame in this process is that, in the last 20 years, we have missed building a significant, material international investment capability in Canada. It has not been in the interests of our financial investment community to staff up the very expensive process of investing internationally, with the result, today, that much of the Canadian pension fund money is being managed out of London, Hong Kong, Tokyo and New York rather than out of Montreal, Toronto and Vancouver.

Mr. MacIntosh: It is worthwhile to point out that to some extent the 20-per-cent rule can be circumvented by constructing so-called synthetic portfolios using derivatives. I am sure you are aware of that, but that takes a certain amount of expertise and not every small fund will have that expertise. It is probably more effective just to do away with the rule.

Senator Austin: We certainly have today a North American money market. In the days when Mr. Benson introduced his budget, there was a separate Canadian capital market. I was sure that that was your answer and I am persuaded that it is the right answer.

If we lift the ceiling, is it your view that it should be lifted gradually, to allow a learning curve, or should we simply drop it totally? If we did that, what would be the consequences?

Mr. Ambachtsheer: I think we could let it go tomorrow with no observable consequences in terms of currency changes.

More realistically, when we campaigned to get the 10 per cent ceiling moved to 20 per cent, we said that just in case there was some short-term movement it should be done in 2 percentage point steps. Our mistake was to say to go from 10 per cent to 20 per cent. Now the recommendation is to go from 20 per cent to 30 per cent and then let it go.

In those economies where there are no restrictions, the U.K. for example, 30 per cent foreign exposure seems to be a natural resting point. In all investment situations there is a natural home country bias related to information. It is not like the natural position will be 2 per cent Canadian, 98 per cent outside. We believe the natural resting point -- and we have checked this with pension funds -- would be about 70 per cent domestic and 30 per cent internal. However, individual funds could have different proportions. We believe the fiduciaries should decide.

Senator Austin: You were talking earlier about informational asymmetry. The further you get from the Canadian base, would you agree, the more asymmetry will exist for the fund manager?

Mr. Ambachtsheer: There are two kinds of asymmetry. There is potentially asymmetry among professionals, but there is also asymmetry within a market between professionals and non-professionals. There are the two phenomena. That is an interesting question. I think it relates a lot to what segment of the market you are investing in.

For example, the broadly traded major bond markets have become very integrated. It is almost treated like one bond market with different currencies. There is convergence toward major multinational publicly traded corporations being treated as one. It is sometimes hard to tell whether IBM is a U.S. company or a global one. There is that segment of the market, and then there is the smaller, more local segment which naturally will be informationally more efficient for local investors.

Senator Austin: I am seeing, whether correctly or not, that in the developing countries -- China being one example, but there are others -- there are enormous numbers of new equities being offered to the international market on the basis of factual patterns that are perhaps less full in their disclosure than we have become used to.

Do you think the market can address that issue or do you believe that there should be some constraints established by standards, either government or institutional?

Mr. Ambachtsheer: Again you are into the challenge of creating knowledgeable and powerful institutional investors that understand the concept of due diligence. As long as there is bottom line accountability for producing results, it is natural that at the top of the list of the people who have the designated responsibility for investing in developing markets would be due diligence.

Mr. MacIntosh: Senator, I would certainly agree with Mr. Ambachtsheer. I would add that there is more informational asymmetry when you go into a smaller developing market and that returns to outside investors are not the same as they are to local investors.

To some extent, the problem is taking care of itself in that many of these developing countries are cognizant of the fact that, in order to continue to attract capital, they must raise their legal standards. If people go into those markets and they do not do well, then they simply withdraw their capital.

One of the more interesting developments in international securities regulation around the world in the last 10 years is a tremendous raising of standards in many of these less-well-developed markets. For example, we have seen the implementation of insider trading laws. Many of these markets did not have those laws. Basic disclosure laws and adoption of accounting conventions will also tend to reduce the informational asymmetries. I do not think they will ever entirely disappear, but I agree that we should leave it up to sophisticated institutions to choose the markets where they will put their money.

Senator Austin: We have seen, however, a tremendous volatility in third-world markets. We have seen tremendous losses taken by funds managed astutely by investment managers but, nonetheless, enormous losses in third-world funds. How does the market explain, after all this diligence, why these losses have been borne?

Mr. Por: I am perhaps the only person in this room who actually grew up in a country where government always tried to protect its citizens from the vagaries of capitalism and the market, which actually was good for Canada because eventually I got sick of this.

Investors are grown-ups. Unfortunately, governments with laws and guidelines cannot protect them from doing certain things. How do markets actually work? Markets look at information and draw certain conclusions in a certain way and try to react. Sometimes there are over-reactions. Eventually, the results will show that overreaction. That is why volatility is permanent. We do not really know the right price of an equity or the right price of a country's equity market.

Senator Austin: So something is wrong with our due diligence process?

Mr. Por: No. This is the nature of the market. There is a famous fiduciary case which is always quoted. Most of you are lawyers so I am on thin ice here. In 1836 or 1837, the Harvard case said: Do what you may, but capital is a hazard.

Surely, you invest in these markets to a certain degree. An institutional investor may put money into these markets at up to 5 per cent. Even if there is a major disaster in those markets, because the fund is well diversified, there is no disaster. People learn to invest in those markets in the same way that people learn how to invest in capital markets here in Canada.

Senator Austin: That is the price then of learning our way in global flows?

Mr. Ambachtsheer: I will give a venture capital example to address your question. There is a 2-6-2 rule in venture capital which is widely known. Everyone knows venture capital investing is risky, so you only do it with a part of your portfolio. But even within that piece, you go in expecting that, of ten investments, two will be complete write-offs, six will be "walking wounded," and two will be big winners.

Senator Austin: Then you will be even as a result.

Mr. Ambachtsheer: In fact, history shows that the Microsofts, if they are among those two big winners, will carry your walking wounded and your dead.

Mr. Ambachtsheer: There is a risky part of the financial markets. Even though it is risky, as long as you have generally a movement towards pricing where risk and reward are reasonably in balance, then just because you know there will be some write-offs, it does not mean you should not go into that area.

Mr. MacIntosh: It is important to emphasize that a large number of studies show that international investing actually reduces your risk. The various international markets are not perfectly correlated. One goes up and one goes down. If you buy a lot of these different markets, you actually have more insulation from risk than if you are just holding one domestic market. You are not putting all your eggs into one domestic basket. You can achieve by international investing a better risk-return trade-off. You can get rid of some of that portfolio volatility.

Senator Austin: That was the theory up until a few weeks ago. Now we are seeing the commonality of market responses because of currency relationships.

I have simply been trying to provoke a discussion. For us, the issue is the degree to which there is a need for public policy to set criteria. I personally favour public policy which allows the market and the institutions in the market to create their own system of checks and balances. The best regulatory system is found in knowledgeable operators, provided their interests are sufficiently diverse and provided there is sufficient power in each of the stakeholder sections to balance the power of other sections.

That brings me to my general question: Are the stakeholders reasonably balanced? You have spoken about governance questions with respect to boards and with respect to the public pension management. You have identified those issues.

We had an interesting witness in the corporate governance study by the name of J. P. Bryant who runs Gulf Oil in Calgary and, to quote him reasonably accurately, he said that corporate governance is nonesense.

Senator Angus: Actually, he said it is guacamole.

Senator Austin: The point he was making was that you must let the entrepreneurs be entrepreneurial; you must let the board understand the business; and, essentially, the investment community should be followers and not governors of corporate performance. There is a risk here, in his view, that institutional standards will blunt entrepreneurial performance; that the institutional system is more interested in the quarterly accounting of revenues and in its own performance than they are interested in the performance of the capital markets or business sector.

Mr. Por: This is a very delicate question because you are asking us to comment on those practices in Canada and the United States which are a source of revenue at least for me. The spectrum is very wide. There is a wide variety of excellence out there, as well as the lack thereof.

Generally, no, we as a society did not think this through. It is one thing to say that a board should be good, impartial, and knowledgeable, but how to produce such a board is open to question. Unfortunately, that is the story of life.

In general, there are few well-governed boards. As a society, or even among academics, we did not agree on what constitutes a good board. The Canadian way of saying this is that the stakeholder groups should be sitting with their representatives, and there will be a board process whereby these issues will play out and the decisions will have a reasonable chance of success. Unfortunately, that view is sometimes cloudy because the very people who are sitting there must actually respond to constituency pressures.

For example, if I am a employer representative working for the government as a middle manager, I have little freedom of decision-making on that board because I am being told by my bosses what to do and what not to do.

We must consider how to ensure the excellence of that board, which is what the CPP is facing. One way is to nominate people to sit on that board. You as the constituency group would not sit on it, and that also holds for governments and businesses. People are reluctant to implement that policy because they lose control. My cynical view of human nature is that control is something which we are reluctant to give up.

However, once there is a good debate concerning what constitutes a good board, Mr. Ambachtsheer and others will help these people know what they should know. There is a tremendous amount of courses and information which has either been developed or is under development, but the notion of what is a good board and who should sit on it is a carry-on point, in my view.

Mr. MacIntosh: In policing management, a balance must be struck. A degree of control over management which is too interventionist can be harmful. An illustration of that is the fact that so many corporations in the United States have incorporated in Delaware. Back in the 1970s, an SEC commissioner wrote an influential article about this move to Delaware. About half of the New York Stock Exchange firms are incorporated there. He noted that the fiduciary standards that pertain in Delaware are somewhat lower than in the other states. It is generally agreed that they are. It turned out that when companies move into Delaware, event studies on share prices show that their prices went up on average rather than down. One of the reasons appears to be that the extra degree of managerial freedom is a good thing. The laws in other states are more constraining than they should be and do not allow enough room for this entrepreneurial instinct to get out.

On the other hand, institutional investors do not threaten management in the sense that they are smart enough not to micro-manage. If they were to micro-manage and look at every little decision and interfere with day-to-day business decisions, we would conclude that institutional oversight would be a counter-productive thing.

Institutions tend to be involved in transactions that occur rarely but are relatively important in the life of the corporation: whether or not the corporation will adopt a poison pill takeover defence, or whether or not the corporation will engage in a merger with another corporation. It is an episodic oversight in most cases and not a day-to-day intrusive oversight.

I do not think corporate governance is guacamole, and institutional investors do have a role to play.

Senator Austin: I wonder about examples. For example, in the field of executive compensation, we see in the United States $100 million being awarded to an executive officer, tremendous share option plans, golden parachute plans, tremendous rewards being given by a board of directors to its management. People keep in mind the way in which the CEO governed his governors. I am not saying that what was in the book is true. I am saying, whether it is true or not, that that is the story, and it is perceived to be part of corporate governance.

Is there a role for fiduciary investors on behalf of the public funds, and so on, at that level, or do they simply say, "The reward is commensurate"? Is the reward commensurate? What is happening, and how does your governance affect that? You referred to co-option earlier in your remarks.

Mr. MacIntosh: Yes.

Senator Austin: Is co-option taking place there, and how can you tell?

Mr. MacIntosh: Co-option is a serious problem. Evidence from the United States indicates that institutions that have business ties with various corporations tend to vote with management much more often than institutions that tend to be pressure-proof. If you ask institutional money managers in the Canadian community, they will tell you the same thing. I do not think we have the same systematic evidence, but that is the answer you always get about why life insurance company are pretty solemn on corporate governance, or banks and some other institutions.

That is why I indicated earlier that this is one of the pressing problems that the committee needs to address in looking at the role of institutional investors.

Mr. Ambachtsheer: The closest thing that we have identified to creating some accountability in the situations that you mention has been the public pension funds, and for fairly logical reasons. They are the funds where there is probably the most clarity of alignment between the governance management and the accountability to stakeholders. It is in their interest to call those kinds of practices into account, and it is the area where there is the least chance of there being some countervailing forces saying, "Oh, my God, we shouldn't be doing that." There are not the kinds of restraints that you see in the insurance industry and in parts of the investment counselling industry. Do you really want to take your best client? It is a problem.

Senator Austin: I am glad you mentioned that point, because I am looking for balance among stakeholders so that there are major stakeholders who cannot be co-opted and will keep the system moving forward and set the benchmarks you mentioned.

Senator Hervieux-Payette: I am talking as a shareholder of Caisse de dépôt, so perhaps I am an outsider in this case. As one of probably 5 million Quebec stockholders following what the Caisse de dépôt is doing, we have an historical background.I have dealt with them in terms of investment. When we talk about criterion and guidelines, and what the government's public policy should be, we are always asking ourselves, when they invest in the three major food chains of Quebec, "Does it help the performance of the three food chains?" As far as I am concerned as a consumer, I do not think so, but that must be proven. What sort of guidelines do you put in place?

When I was in telecommunications, we went to the Caisse de dépôt, and they said, "Sorry, we have already invested in your competitor." Why in one case would they invest in all the players and in the other case not? It seems that there were no criteria given. One of the original functions of the Caisse de dépôt was to pay the pensions, but it is also there to create jobs, wealth, and to reinforce the economy of Quebec. Can we have four goals with the same fund?

Do we need criteria? Where do you find these champions? They will have a difficult time to find women because they will say that they do not have the experience. I will recommend to my Prime Minister that there are probably many nuns who have administered their congregation and could qualify. We have one now in the Senate.

We must find people who would almost need to be saints. They should make all their decisions in the public interest and forget about all other interests.

The guidelines or criteria are important because we will be dealing with human beings, no matter how experienced they are.

Also, speaking of investment, some Canadians think that capitalism is somewhat savage. When it comes to investing in an environmentally hazardous company, or in foreign companies in which children are working or where human rights are not respected, should we recommend some rules if we want to enlarge the percentage for foreign investment? Should we say that foreign companies that do not comply with Canadian standards are not eligible for investment by these funds? It is important that we have a set of criteria with which Canadian people will be comfortable. We have our own standards and values. If we apply the total capitalist system, there are no rules. You just put your money where you have the best return. In terms of public interest, how do we balance this? I welcome your suggestions.

Mr. Ambachtsheer: I think it is problematic to mix what I would call fiduciary investing, where there is accountability directly to the stakeholders, those who have the assets, and an economic development sub-objective. It is clear you have a problem. You are then faced with trying to figure out whether you are transferring wealth from your stakeholders to some other situation which you would not do if you did not have that secondary objective. It is problematic to saddle investing institutions with the obligation to be fiduciaries, on the one hand, and on the other to be responsible for a different objective.

With respect to women, my observation is that they are doing very well. If you look at it on a global basis, in pension fund fiduciary, both governing and managing, two of the largest funds in the U.S. are actually run by women.

The other observation I would make about Caisse de dépôt is with respect to the transparency issue. They do take great care to report their annual results each year. They hold a press conference, and it is reported in all the newspapers. Unfortunately, I think they are creating data but not necessarily information and knowledge. The problem is that Caisse is an investment manager managing at least seven different balance sheets. There is automobile insurance, workers compensation, the Quebec pension plan, the public service plan, et cetera, but they add them all together and report one return number. That is not information. They should be reporting information about how those seven balance sheets are doing and then that can aggregate up to some total number. Perhaps they should be encouraged to rethink what they can do about creating information.

I do not know what to do about the economic development sub-objective. I think it is a real problem. I will now turn it over to my colleagues.

Mr. MacIntosh: You have a problem when you have a fund with two mandates. I will tell you about a study that I mentioned in the background paper by Roberta Romano of Yale University. She looked at the performance of public pension funds versus other pension funds and found that the greater the number of political appointees to the board, the statistically worse was the performance of the fund. In addition to that, many states have legal structures that permit funds to invest in local enterprises, even if they do not have the best risk-return trade-off. That was also a statistical factor in lowering fund performance.

The difficulty I see with having dual mandates is that it is a way for the state to disguise expenditures. That is, the extent to which the low performance impacts on the ability of the fund to make good on its pension promise nominally comes out of the hides of the beneficiaries. Of course, if it is a defined benefit plan, the state simply has to step in and top-up the plan. So, really, it is the taxpayers who ultimately foot the bill. It can be a way of subsidizing local investments and disguising that subsidization by routing it through a public pension fund. If the government wants to adopt local investment initiatives, it should do it more directly, in a way which is more visible.

Mr. Ambachtsheer: I wish to add something which is very important. The Auditor General in the Province of Quebec recently had some questions about the Caisse, and there were hearings in the National Assembly on the Caisse. The Caisse created a seven-minute video about what they did. I should disclose that I was one of the two people invited to say something about that video. Let me say here what I said then: If you look at the performance of the Caisse, balance sheet-by-balance sheet, they actually performed very well. That is something that I do not think they have communicated effectively to the constituency. This economic development program affects probably only a small percentage of their assets, and not the other 98 per cent. The problem is actually much smaller than a lot of people make it out to be. A lot of these things relate to effective communication.

Senator Tkachuk: On the question of how large a pension fund is and how it performs, you mentioned $1 billion as the cut-off. Over $1 billion, is bigger better?

Mr. Ambachtsheer: Yes.

Senator Tkachuk: So if you were comparing a $1-trillion fund and a $2-billion fund, the $1-trillion fund would perform better? In other words, statistically, did the pension funds perform better as they got bigger?

Mr. Ambachtsheer: It gets a bit anecdotal because there is only so much you can learn from an 80-sample data base.

Of the eight sponsor funds that I mentioned earlier, those with an average size of $50 billion U.S. -- which is $75 billion or $80 billion Canadian -- we had performance data on seven. The eighth did not have data long enough to be part of the group. They were the dominantly large funds out of the 80 and collectively they had risk-adjusted net performance far superior to the entire sample. When you look at the plot of the 80 dots, out of the seven for which we had data, six performed very well and one did not perform quite so well.

Again, I do think it is a continuum. As to whether there some ultimate figure -- you mentioned $1 trillion -- I do not know. We do not have data that high. But when you look at this issue in a global context and use numbers like $50 billion, $60 billion, $80 billion, in the scheme of things they are not particularly large players in the global marketplace. That is the right perspective.

Senator Tkachuk: On the question of the shareholders of a fund being involved within a company, it seems to me that they had another choice: They could have sold the stock and got out and gone somewhere else. When they go into that, are they trying to justify a bad investment in the first place? In other words, when they made that investment in the first place, they were betting on the management doing well. Obviously the company did not perform well, so now they are saying, "Perhaps we should be involved in this company to improve its performance." Managers might say, "I was the one who decided that we should invest $50 million in stock in that particular company and I will make sure that investment works if I have to take over that company." Or would they have done just as well had they sold those 10 and bought Microsoft?

Mr. MacIntosh: In fact, the study shows that the cost of CALPERS' corporate governance program was relatively small. It was $500,000. The aggregate increase in value achieved in the companies looked at in the study was $137 million. Presumably, the answer is that they did a lot better by getting involved and by increasing the performance of those companies. Some $137 million minus $500,000 is a pretty good cost-benefit ratio.

Senator Tkachuk: We do not know for sure if they would have not been involved and done something else.

Mr. MacIntosh: The important point here is that those are returns above the market. That is to say the market return during that period of time was subtracted out. The $137 million is what an economist would call an abnormal return, namely, a return above what you would have received just by taking that money and investing in a random market portfolio -- buying the index, for example. The market performance was actually accounted for in that $137 million.

Mr. Por: This whole notion of large American funds is a bit overblown. I happened to have gained work with these companies. They are much lower-key. I saw the same study and I must question the $500,000 expense. In monitoring these companies, I know how much money they happen to have paid for a number of transacting firms to do so.

The issue is not necessarily whether it could be proved economically what would have happened had they done so because you never know. Most of these funds -- and Mr. Ambachtsheer may want to comment on this -- are fundamentally passively managed in the U.S. because the dollars are so huge that they have a problem finding corporations in which to invest. In most instances, they are forced to invest in an index.

Once you invest in an index, the only way you can influence the fund's performance is to go to the corporations and talk about what and how. The issue is not necessarily that they should or should not do it; the issue is by what format, by whom, at what level and at what cost. Lately, I find that the role of pension funds in corporate governance is cut back very significantly.

Senator Tkachuk: Public sector pensions with defined benefits are unique entities in the sense that the people most affected are those who are at the end of the rope who, when they turn 65, receive a pension. They do not care, or they have less self-interest in caring because they know what their pension will be. The government is backing it up in a lot of cases. Why would the person who works in a provincial or federal park cutting the grass, or the person managing the park itself, care? If they know what they will receive and the government will back it up, why would they care? The people who care about pensions are the people who are at risk. If you are not at risk, then why would you care? Perhaps governments should be involved in this because we have our own stake, in that, in the end, the taxpayer must pay for bad pension plan management.

Mr. Ambachtsheer: I do not think it is incidental that one of the best governed pension plans in this country is the Ontario teachers' pension plan. It is one of the few public plans of which I am aware anywhere in the world that has achieved crystal clear clarity about what is the real pension deal. It is a 50/50 partnership.

There is an estimated normal cost for the plan, which is about 16 per cent of pay. It is quite a rich plan and fully indexed. If going forward the investment results were not up to the expectations that were used to calculate the funding, there would have to be a top-up. There would have to be more money put in. That is the at-risk question.

The 50/50 partnership in the case of Ontario teachers means that the contribution rates of the taxpayers and of the teachers go up by the same amount. It is a clear risk-reward, symmetrical relationship between the two part partners.

A lot of other public sector plans have not achieved that clarity. As the federal public service plan is kind of put out on its own as a separate standing system, I certainly hope that the risk-reward deal between the plan members and the taxpayers will be absolutely clear.

The Chairman: You all talked in various ways about the quality of board members. You all used that phrase in different contexts. Mr. Por, in response to Senator Austin, made the observation that no one is quite sure what that means in a definitive sense. As you said, it is an exploratory issue.

Given the importance that you have all attached to it, including Mr. Ambachtsheer's study, it would be helpful for us, at the very least, to have your guidance as to what constitutes "qualities" in a board. Or perhaps the question should be what constitutes "non-quality." Sometimes you can define one by a process of exclusion.

I would ask all three of you to give some thought to that question and to send us a letter in response to it. If one of the outcomes of this study is simply the urging of pension boards, in particular public sector pensions, to adopt a quality criteria for their board, I think we then owe people an obligation to define what quality means.

Gentlemen, thank you very much for your attendance here this morning. It has been a stimulating morning.

Subject to agreement between Senator Tkachuk and myself, is it agreed that we approve the budget for next week's CPP hearings? We have to take it to Internal Economy on Thursday.

Hon. Senators: Agreed.

The committee adjourned.