Proceedings of the Standing Senate Committee on Banking, Trade and
Issue 20 - Evidence - May 28, 1998
OTTAWA, Thursday, May 28, 1997
The Standing Senate Committee on Banking, Trade and Commerce met this day at
11:00 a.m. to examine the state of the financial system in Canada (the role of
Senator David Tkachuk (Deputy Chairman) in the Chair.
The Deputy Chairman: Our witness today will, I believe, be most helpful to us in
our study. He is Dr. Laurence Schwartz, chief economist with the Toronto office
of LECG, Inc., which is a leading North American consulting firm in the
provision of expert economic analysis for litigation and regulation.
Welcome to the committee, Mr. Schwartz. I believe you will give us a short
summary of your presentation and then we will have questions.
Dr. Laurence P. Schwartz, Senior Economist, LECG Inc.: I wish to take this
opportunity to offer something of a dissenting opinion on the question of
mutual governance. Had this session gone as originally planned, Commissioner
Stromberg would have been here. Commissioner Stromberg and I have discussed
these matters on a few occasions. She is well-accepting of my dissenting view,
and I have every regard for the commissioner and the work she has done in this
area. It is a matter of a disagreement on this point.
The chart which I have provided, headed: "Arrangements in the Mutual Fund
Business," might help clarify some of the relationships that exist among
mutual fund management companies, the funds that they manage, and the investors
in those funds, which we call "unit holders." On the right-hand side
you see the distribution, that is, how people's money gets into mutual funds.
They are distributed through stock brokerages, mutual fund dealers, financial
planning companies, and my happy faces are those people who are not yet unit
holders but are prospects.
The relationship between the fund management company and the funds is
established through a trust document and a management contract. For each pool
of funds, a money market fund, an equity fund, a mortgage fund, there will be a
separate trust document and management contract with the fund management
company. Shifting to the right-hand side, you see the distribution agreement
that the fund management company in its role as principal distributor enters
into with each of the various distribution companies it want to use to
distribute its funds.
I want to talk about the arrangements. When we talk about the mutual fund
business we are not necessarily clear on what is meant by that, so I hope that
this will assist. When we talk about mutual fund governance, we are talking
about the pools, and they are circled, the money market fund, the equity fund,
the mortgage fund, and what kind of governance apparatus or institutions we
should have in relation to those pools. We are not talking about the
distribution of mutual funds.
Many types of abuses could take place with respect to people who have put money
into these pools, abuses such as self-dealing, conflict of interest, stealing,
or taking assets out of the pools for one's own benefit. Those are the kinds of
abuses which a governance system might attend. Frankly, we see little of that
in Canada, and I am not aware of any lawsuits, any litigation, or any instances
of wrongdoing in this country. That is not so in the American situation.
There is, however, abuse in the Canadian mutual fund business but it tends to be
on the distributor and prospect side of this diagram. By that I mean that a
salesman will attempt to bring in a prospect with outlandish claims of
performance, such as claiming that the fund will double in three years or five
years; or the salesperson might try to persuade an elderly investor to put a
mortgage on his or her house and use the proceeds of that mortgage loan to buy
into a fund that he is distributing. Those kinds of abuses are very real, and
they are common. Securities regulators across the country are well aware of
them and they should do something about them.
However, the governance issues we are talking about have almost nothing to do
with those kinds of abuses. We should be clear, because it is not entirely
clear in the minds of those who think that mutual fund governance ought to
change in some way, what abuses they are trying to control.
There are now three proposals on the table to reform mutual fund governance in
Canada. Commissioner Stromberg, in her report to the security administrators a
couple of years ago, said, in essence, that every single mutual fund should
have its own board, with directors having corporate type responsibilities, and
that a majority of each fund's board should be independent. She did not go into
too much detail about what would comprise independence.
That proposal was reviewed by the investment fund steering group which was set
up by the chairman of the Ontario Securities Commission to review the Stromberg
report. In the area of governance they agreed, unequivocally, with Commissioner
Stromberg that every mutual fund should have a board, or that there should be
boards, and that they should be comprised of 50-per-cent-plus independent
The report made a puzzling conclusion. It found that not every single mutual
fund in Canada ought to have one of these boards, but that there should be one
board for every fund family. For example, if one company sponsors a money
market fund, an equity fund and a mortgage fund, there would be only one board
for that set of pools. That is the second proposal, a board for fund families,
but still independent.
In the report of the Quebec Consultative Committee, which reviewed the Stromberg
report from Quebec's perspective, it was stated that fund family boards are the
way to go. However, they could find no reason for them to be independent.
There is a whole range of proposals out there for fund governance amendment. It
is interesting to note that, if you read these reports, you can find no good
reason why the change is being proposed. Commissioner Stromberg's rationale was
very clear. She prefers the corporate structure. She has stated that court law
is a much superior way to regulate these kinds of relationships and that is why
we should do it. She did not say there was any abuse in Canada, and she did not
point to any court cases, any litigation, any regulatory proceedings that would
affect the kinds of relationships between unit holders and mutual fund
management companies that might require a board to intervene. She has a
preference for corporate-style structures.
The follow-up group, the investment fund steering committee, apparently agreed
with her because they also could produce no evidence. That was a group which I
would have thought was well able to produce evidence, if there had been any, of
the abuse of existing investors by funds and fund management companies. In
fact, if you were to read that report it would strike you that there was no
rationale offered as to why we ought to accept their proposal over Commissioner
Stromberg's. It seems to me, if they agree with Commissioner Stromberg, as they
do, then they ought to have said that every mutual fund needs its own board.
They did not say that, and they did not tell us why, they just put it out for
consideration. I find it very puzzling that a knowledgeable committee, struck by
the chairman of the Ontario Securities Commission, should make a recommendation
but not give its rationale for the recommendation. There are rumours but, since
I cannot confirm them, I will not get into that.
What these models suggest to me, frankly, is a certain lack of understanding as
to why the current regime in Canada is what it is. I once worked at the Ontario
Securities Commission. No one was interested in the issue at that time but no
one seemed to have a good grip as to why the regime we have today was in place,
with one slight exception. People at securities regulatory authorities in the
country are aware of the 1969 report of the Canadian Committee on Mutual Funds
and Investment Contracts. That was a federal-provincial study conducted by a
group of provincial financial services administrators supported by a staff.
Among the administrators was a federal representative, the Honourable Marc
Lalonde, and the staff was headed by Mr. James Bailey, the present head of the
Tory, Tory, Deslauriers and Binnington law firm and former head of the task
force into the future of the financial services sector.
In 1969 they reviewed the gamut of issues having to do with mutual funds, their
regulation, and they did spend some time on the governance structure of mutual
funds. That report is now approximately 30 years old and, since it is
approximately 600 pages in length, it is not surprising that few people take
the time to read it. I am referring to those in the regulatory community, in the
business community of mutual funds, and investors. No one seems to know,
without having read that report, why the current governance structure is what
it is. I contend that is the reason for some of these problems.
I go into this in more detail in my paper. Suffice it to say that, on the
question of governance, the committee took two views about what a mutual fund
actually was. To simplify, they found that a mutual fund could be viewed as an
organization in which an individual, who comes into a windfall and who does not
have the wherewithal to manage his money, could invest his money. That person
could go to an investment counselling firm and ask them to manage his or her
money. There would be a fee arrangement. The committee suggested that perhaps a
mutual fund was a vehicle which could be used by these people who have money
and who do not wish to manage it themselves, but wish to leave that to a money
manager. On that theory, a mutual fund is simply a vehicle that the money
manager establishes in order to facilitate the pooling of the individuals who
come to him for money-management services. If you have ever gone to an
investment counsellor, and after a while you were dissatisfied with his
performance, or the way he administered your money, you would simply take your
money and go elsewhere. There would no thought that there ought to be a board of
directors to whom you might appeal in those circumstances. That is not the
theory of how investment counselling works. If you do not like how your money
is being handled, you leave.
That was one theory of the mutual fund that this 1969 committee considered. The
alternative is more like the corporate investment. They suggested that we could
think of a mutual fund investment as being the equivalent of buying stock in a
company. When you invest money in a mutual fund you get back units that
represent your interest; similarly, when you buy stock in a publicly listed
corporation you get shares and you become a shareholder.
In 1969, the committee went back and forth between these two views. The
committee said that, if the mutual fund is a corporation then we should adopt
corporate governance attributes, and it may make sense to have independent
director requirements for that corporate-style fund organization. That
committee took the view that the corporate style was, essentially, the American
model established under the Investment Companies Act of 1940. The Americans
have had many problems with the way that legislation has been implemented, with
the administration, with the regulations it gave rise to, and particularly the
question of the independence for directors. It was asked, "Where would
these people come from?" and, "Who could be a director?"
The Investment Companies Act specifies that 40 per cent of the boards of
investment companies, which is what they call "mutual funds" in the
States, must be independent. However, it was not clear how independent a person
had to be to meet the statutory test. By way of example: A few months ago, I
had occasion to speak to an American at a conference. He worked in a bank. He
noticed that some of his employees in the bank were qualified and were the
independent directors of the mutual funds which were managed by the bank's
mutual fund management subsidiary. It is clear that in the United States if you
were an employee of a mutual fund management company, you would not be
independent, but apparently in the United States, when that mutual fund
management company is owned by a bank, the employees of the bank qualify and
can pass the independence tests. This demonstrates the problems of defining "independence."
These are some of the issues dealt with by the 1969 committee. The long and
short of it is that they found that mutual funds ought not to be viewed as
corporations, and that they need not be required, in their view, to have
formalized corporate governance. However, they did find that it was a good idea
to have independent directors but they did not recommend that it be made a law.
They opted for the former model in which people give their money to a money
manager, the money manager establishes a pool, and people are free to come and
go from that pool. Since it is not a corporate structure, there is no formal
corporate governance apparatus. That may seem inappropriate to some people, but
there is a rationale for it which stems from the difficulties inherent in the
I would suggest that what we have, not entirely but largely, is a system of very
active governance on mutual fund management companies that comes from the
ability of investors to come and go as they please, to redeem at net asset
value on approximately a daily basis in most cases.
The 1969 committee was not content with that rationale. They did not think that
the ability of people to redeem on demand would be enough to protect their
interests so, rather than go the corporate route, they determined that there
was reason to have strong regulation in Canada over the mutual fund business,
That is what we have today. We have a system where there is strong and
interventionist regulation; and there is a system where people come and go
pretty much as they please at net asset value. I have yet to see any evidence
that this system has not worked out extremely well. The lack of litigation, the
lack of hearings, the lack of demand for corporate directors, outside of
Commissioner Stromberg and the follow-up people on her review, all point to the
fact that it is working well. However, there it is still an open-ended question
here as to whether this open-ended governance machinery would be an
improvement. I do not believe it would be because our system seems to work very
The Americans are finding themselves in a bit of a conundrum because they have a
system which, in my submission, is slowly but surely moving towards a
Canadian-style approach. In my paper I mention the 1992 report of the Division
of Investment Management of the Securities and Exchange Commission. They took a
look at what they called the "Unified Investment Fund," which is their
name for what we have in Canada, and they contrasted it to what the American
legislation requires of what they call "investment companies." The
principal governance technique in the law of the United States requires that
every single mutual fund or investment company have a board of directors, at
least 40 per cent of whom are independent of the management company and of the
fund. Quite apart from the definitions of independence and the problems that
may entail, that is the rule. The Investment Companies Act also specifies that
these investment companies shall issue shares. They do not issue units as we do
in Canada, they issue shares; and the people who invest in these investment
companies are called "shareholders." They are not called "unit
It is very clear that the Investment Companies Act of 1940 is an attempt to turn
the conventional mutual fund into a corporation, at least for governance
purposes. It could be a corporate structure, it could be a trust, nevertheless,
the Investment Companies Act imposes these corporate governance provisions on
The staff who assisted in the preparation of the 1992 report in the United
States, considered the law in the United States as it applied to these UIFs,
the unified investment funds, and they concluded that they liked the model they
had in place, the model they adopted in 1940, and they decided not to change
it. They said to change it to a Canadian-style UIF would be to contradict the
legislative history of their act. They are quite right. One thing that the
United States has that we have not had, as far as I can tell, is a history of
abuse. The abuse that I have documented in my paper goes back to the 1920s and
1930s before the Securities Exchange Act, before the history of U.S. mutual fund
or securities regulation, and there were some gross examples of abuse of
investors by the managers of those mutual funds. Those abuses were so gross
that they gave rise to the Investment Company Act of 1940 and to the corporate
style of governance that it was believed would address those issues.
It is interesting, if I may say, that most of the mutual funds in the United
States in the 1920s and 1930s were close-ended corporations. That is to say, if
you were an investor in one of those funds, you did not have the right to
redeem on demand. You had to look to the stock exchange to find a buyer for
your mutual fund shares when you wished to exit. Maybe you could find a buyer
and maybe you could not. Maybe you could get a price close to net asset value
or maybe you could not.
Although we have them, those funds are not so common in Canada. There are
certain specialty funds, and there may be a reason to invest in them, but I
would say that 90 per cent of conventional Canadian mutual funds are open-ended
and, therefore, permit this redemption on demand at net asset value.
Interestingly enough, most American mutual funds are now of that type. The
overwhelming number of American mutual funds are open-ended, but they continue
to have imposed on them the governance apparatus of the 1940 legislation that
was introduced to respond mainly to the abuses in close-ended funds in the
1920s and the 1930s.
Having said that, I believe that the Americans are moving towards another type
of fund, although it will not happen immediately. The 1992 report mentioned the
fact that they will never have the kind of funds of which you and I speak. They
have, however, taken some steps. For one thing, the staff of the securities and
exchange commission suggested they ought to move the 40-per-cent independence
requirement for boards up to 50 per cent plus. It is of interest to me that that
proposal did not find acceptance with the Congress, although a number of their
other staff recommendations were accepted.
The report also questions the success of the governance apparatus. They noticed
that, despite the fact that these mutual fund companies are required to have
annual meetings, very few investors attend; and when proxies are mailed out
very few people respond. That might not be surprising to anyone at this table,
but that is the American experience.
They also noticed that the independent directors tend not to do their job. They
rarely terminate the money manager, the one who started the fund. Even when
they challenged the fees that the fund was paying the manager, they would
settle on a number that was only marginally below the manager's initial
proposal. The staff report also suggests that independent directors rarely
challenge self-dealing or conflicts of interest.
You must wonder whether the staff have engaged in a contradiction, particularly
when they conclude that they will not go to the unified fund that is used in
They did, however, in the 1992 report, recommend that certain shareholder voting
requirements be removed. I refer to two in my paper. They decided that, in
certain cases, shareholder votes would not be held because fund investors, by
investing their dollars, have already chosen the arrangements.
From this, I conclude that, in the United States, there is some movement away
from the very heavy-handed corporate-style governance regime that they have
imposed on their mutual funds, and that they are heading towards something that
relies on redemption -- on net asset value on shareholder movement, if you will
-- to discipline the fund management companies.
I believe your committee may have other concerns. Bearing that in mind, Mr.
Chairman, I am prepared to conclude my preliminary remarks if members have
The Deputy Chairman: We will proceed to questions. If we do not cover all of the
areas you wish to bring to our attention, you can come back to them.
Senator Callbeck: Mr. Schwartz, does the sales code rule that was introduced
cover the kind of abuses you mentioned in Canada where a sales person may
promise unrealistic returns to encourage someone to mortgage their home?
Mr. Schwartz: It does.
Senator Callbeck: Who enforces that?
Mr. Schwartz: I cannot be sure at the moment. It is a code that was established
by the industry itself through its trade organization, and I believe the
Ontario Securities Commission and presumably others have attempted to give it
some legal or self-regulatory basis.
Senator Callbeck: Would that address that problem?
Mr. Schwartz: Yes. Those are the kinds of abuses that they are trying to
addressed by the sales code, as contrasted with the abuses that might give rise
to a governance system. For example, a governance system would deal with the
situation where, if you are already a fund investor the money manager changes
the fees on you, converts the fund to cash and goes to South America, or where
the fund has purchased assets from the staff of the fund management company in
contradiction to the stated investment policy of the fund. As I said, I am not
aware of any such complaints in Canada, but those abuses are not the kinds of
abuses that the sales code is designed to address. The sales code is concerned
with regulating the sales practices of those people who are selling the funds.
In fact, if we did have a fund requirement in Canada for boards of Commissioner
Stromberg's type, and those directors did observe abuses on the sales side,
there is very little they could do about it. Those prospects did not vote the
directors in, and the directors are not there to look after their interests.
They are not the responsibility of the directors. Their responsibility is to the
people who are in the fund. They voted the directors in to represent their
Senator Oliver: They would be the agent for the company.
Mr. Schwartz: I believe, senator, that that is what I am disputing. If we
required fund directors to be there and to be representatives of the investors
in the fund, then that is how they would draw their authority, in the same way
that corporate directors draw their authority from existing shareholders.
I may be wrong in this, but if I was a director of a publicly listed company and
I saw a stockbroker making outlandish claims to other people, I may not like
it, but I am not sure that I could do anything about it. As well, I am not sure
there is anything I should do about it. I am certainly not going to dip into my
company's assets to mount a lawsuit against this salesperson. That is not in the
interests of the existing shareholders, at least in the normal course. For the
most part, I do not believe that corporate directors see themselves as having
that concern. They are not worried about people who are not stockholders; they
are worried about the stockholders.
I will take my hypothetical situation one step further. If you believe that
these hypothetical fund directors act in the best interests of their unit
holders, then the more money in the fund the cheaper the unit costs of
management. It is beneficial, therefore, for the fund to grow because the cost
to the existing investors will be lowered. Thus, the hypothetical fund
director, in my scenario, will turn a blind eye to the sales abuses because he
is not responsible for sales people; if their money comes in, it is of benefit
to the existing unit holders.
That is speculation on my part, but I almost think that this might have negative
consequences for sales practices, if anything. I do not speak as an expert on
this, but I have been told that I am right by some people; by others, I have
been told that I am wrong, however. I believe I have an idea of what directors
do and that the expertise of this body may contribute to your collective
thinking about how directors would respond.
Senator Callbeck: Just to carry through on that, is it fair to say, then, that
you feel that the abuses that we tend to see in Canada are addressed by that
Mr. Schwartz: I have not been involved with that in any way. I am aware that it
is the intention of those sales code to address abuses of that type, as opposed
to the abuses that I have discussed.
Senator Meighen: Do I have it right, Dr. Schwartz, that in effect, as I
understand what you are saying -- and I agree with you at least in the logical
progression -- there is no logical rationale to have "independent"
boards of directors in open-ended mutual funds but that you see no harm to there
being some? Would I also be right in saying that, indeed, the trend seems to be
towards more "independent" boards of directors for open-ended funds?
I should tell you right away that I am the chairman of Cundill Funds, and they
have had a board of directors, or the venture fund has had a board of directors
since the late 1970s, early 1980s.
Mr. Schwartz: I believe that the 1969 report put it very well: It is desirable
to have independent directors, if you can find them and if you can somehow make
then responsible to the investors. It is not clear how you would elect them,
but assuming those problems could be overcome.
I am not opposing the concept of independence. I am opposing the requirement. I
am not certain, senator, whether there are many boards on mutual funds. There
is a movement to advisory committees and advisory boards, and I believe there
may well be a role for those. The advisory boards that I read about I believe
have very little in the way of responsibility or authority. I do not know what
they do. I am just a little sceptical of their impact.
I am a participating policyholder for an insurance company. This company
annually establishes an advisory board of knowledgeable people to interview the
manager, and interview anyone they choose, and then report to the
policyholders. That is a very useful thing to do. They are independent, no
doubt, and they are qualified. I am not aware of any advisory boards of mutual
funds in Canada that do that. I am sure they meet and they probably do the best
they can, but I do not have the sense that they are terribly influential.
Senator, you may be in a minority if the fund you are part of has a board, in
the corporate sense.
Senator Meighen: I believe we are. What we do is interesting. For example, we do
not have a sales force; independent organizations sell our mutual fund units,
if they so desire. We do not feel that we have any responsibility whatsoever as
a board vis-à-vis, say, XYZ Planners Inc., who are selling all kinds of
funds, including ours. They are governed by other codes and authorities, as you
We do feel we have a responsibility to try to ensure that the fund manager is
doing what he says he will do in his information circular and in his annual
reports -- for instance, his policy on derivatives. We try to monitor his
adherence to that stated policy. We monitor that he is adhering to any other
public statements that he puts out. I agree with you that if he decides to raise
his fee by half a per cent, then the unit holders will vote with their feet,
because it must go to the unit holders. We do not bring any judgment to bear on
Mr. Schwartz: I wish to restate that I am not opposed to the independence of
directors or people operating in that advisory role. If we were to make our
system more or less like the American one, then I would expect a higher degree
of litigation and a higher degree of regulation, which is characteristic of
their system. I have some familiarity with one particular line of cases in the
United States, called the excessive fee litigation. In this instance, under the
class action rules that apply in the United States, someone will get up and say
that the fund manager has arranged for himself to be paid too much. The last
time I checked there were at least 60 of these cases, which is perhaps not a
large number, but it is there and they always lose in court.
We never see anything like that in Canada. I am not aware of any instance where
a mutual fund investor sued the management company, but we do have,
interestingly enough, in some of the provinces, class action litigation
capabilities, I believe in Ontario, Quebec and British Columbia.
If we were to go the American route, we would be opening the door to what I
regard as largely frivolous litigation. That would mean, of course, that there
would need to be more rules to control the activity. People may wish to compare
the Investment Companies Act of 1940 and the regulations thereunder with the
lesser degree of regulation of our security rules.
Senator Meighen: I tend to agree with you, I would not like to see that. In the
end, the statement can be made that the board that I am familiar with is more
of an advisory board than a corporate board, an advisory-type board, which I
believe you were alluding to earlier.
On the question of closed-ended funds, I understand that they are not nearly as
common in Canada as they are in the United States. However, am I not correct
that there is a requirement that some of them be incorporated under the Canada
Business Corporations Act, or the Ontario Business Corporations Act, or
whatever, where there is a requirement for a board?
Mr. Schwartz: Those funds are indeed corporations so they must meet the
corporate law requirements.
I might say -- and I have written about this, although not in this context --
that many of the specialized funds, and it may be more true in the United
States, deal in non-liquid securities. If you wish to buy a Korea fund, say,
that invests in Korean securities and the Korean Stock Exchange, or whatever --
countries are of this type tend to be non-liquid, they are not often traded. In
that case, the fund would be well advised to be organized on a closed-end
basis, because if I, as an investor in the Korea fund, wished to get my money
back, the fund manager would need to start liquidating the fund's assets.
Holding a portfolio of the non-liquid securities, Korean stock exchange listed
securities that cannot be sold readily, would put the fund manager in a bit of a
bind if he was required to meet daily redemptions because he might not be able
to find buyers for the stock of the fund. That is a good reason to have
closed-ended funds. And since they are closed-ended, they should have corporate
governance. Someone then must be watching over the manager because there is less
of a market test.
Senator Austin: My understanding about open funds is that the manager is
required to protect the fund holders by placing assets in a trust company
holding. Am I correct in my understanding?
Mr. Schwartz: Not a trust company. There is a declaration of trust by which the
management company establishes the pool. That pool, therefore, must have
The 1969 report asked whether the trustees established pursuant to the trust
arrangement should not be required to be independent, and that committee said "no"
and they noted a problem. For example, Montreal Trust Company, which offered
mutual funds back in the 1960s, or wished to do so, would need to get, say,
Central Trust to be its trustee. The committee decided that having competitors
be trustees for each other's products was not a practical arrangement.
Senator Austin: What is the value in day-to-day terms of that trust company
arrangement? They will act on the instructions of the fund manager. What
independent role do they play?
Mr. Schwartz: As I said, at the moment there is no requirement for a trust
company, there is a requirement for a trustee.
Senator Austin: Correct, and most have used trust companies at one time or
Mr. Schwartz: Senator, that is not my impression. My impression is that the
trustees are often employees of the management company but they are subject to
the declaration of trust. What there is, is a custodial relationship, where the
fund's assets, or increasingly these days the computer chips on which the
fund's assets are recorded, are held in a bank or some financial institution.
One arrangement that is not on this chart is the custodial relationship. There
is a difference between the trustee and the custodian.
Senator Austin: In the event of the commission of a serious crime that
diminished the assets of the unit holders, what would be the responsibility of
Mr. Schwartz: I do not know. Of course, senator, that is the concern.
Senator Austin: What is the policy behind a trustee?
Mr. Schwartz: I presume the fund is set up as a trust to separate the assets of
the fund from the assets of the management company, and I presume the trustee
is there in some sense to look out for the interests of the investors. I fully
admit that it looks terrible on paper if the trustees are employees of the fund
management company, but I counter that with the absolute lack of any such crimes
in our history. I do not know how many years you wish to go back; as bad as it
may look on paper, there just does not seem to be a problem here.
Senator Austin: You refer to the Hirsch matter in your paper, and there have
been other, more recent, news stories about front running by managers.
Mr. Schwartz: I was thinking less of the front running than by this Altamira
employee, Frank Mersch.
From my reading of Hirsch and Mersch, their behaviour indicates, from my point
of view, if I were an investor, a certain lack of ethics, a certain lack of
understanding of my interests as an investor, but they have not done anything
to diminish the interests of their unit holders. Mersch is alleged to have lied
on a totally unrelated matter to a securities commission. I do not see in that
anything that has damaged his investors. People will leave that fund now, to
some extent, I am sure, because they now view their fund manager as lacking
certain ethical characteristics.
Senator Austin: May I offer the conjecture that if they were acting totally as
fiduciaries for their holders, those opportunities that were put in the names
of others -- and their explanations were that the others were the true
beneficial owners -- should have been for the benefit of the unit holders.
Mr. Schwartz: I am not aware, senator, that that has happened, although it may
be the case. The subsidiary point perhaps is that there is a lot of rumour here
in the community. Everyone I talk to seems to know something wrong that
happened somewhere. There is much innuendo but there is no evidence. No one
ever comes forward with evidence that such and such a person did such and such
to his investors on this date. All there is at this point is speculation.
Your committee would benefit the country if you asked for evidence, asked people
to put what they know on the record, and then we can judge whether our
governance machinery is working or not. The rampant speculation that I get is
just that. For example, Hirsch was out before she started. Fidelity bought her
off from AGF -- she was to be the manager -- but her own personal investing
malfeasance came out before that fund got started. When it came out, the
Fidelity people wasted no time, they tossed her out. They knew that they could
not have a person like this managing their fund. I believe the Altamira people
came to the same conclusion about Mersch. Even if it is only alleged, people
will redeem out of these open-ended funds on a whim. Any whiff of bad conduct or
bad ethics is enough to get people to leave.
One of the very strong aspects to our system is that there is a certain
alignment of incentives. The management company has no incentive to hire people
who will harm the investors. Under a closed-ended structure, yes, because the
management company does not care. It is up to the people who deal on the stock
exchange to get rid of their units, and that of course was the problem in the
States in the 1920s and 1930s.
Senator Oliver: I first wish to know whether you know John Por and whether you
know of his writings and work in terms of corporate governance for
institutional investors? Have you seen the evidence he has given before this
Mr. Schwartz: I have not.
Senator Oliver: He drew a relationship between good governance and good
performance of the funds, and, in his view, there is a correlation and a strong
I also wished to ask you a series of questions about institutional investor
activism. It is not one of the topics that you have addressed today, but it is
something that we have had much evidence on and that we likely will be
addressing in our reports. I wish to hear from you whether or not there are any
governance principles involved in institutional investor activism -- I am
talking about the CalPERS examples -- that you feel we ought to be having a
look at; and, if so, what are some of them and do you have any view on the way
these funds vote their proxies, and so on?
Mr. Schwartz: I have not done much work in the field. I did, however, co-write a
paper with Professor Jeff MacIntosh, who is with the University of Toronto law
school, that was given at an Industry Canada conference a couple of years ago.
We tried to find some evidence for the relationship that controlling
shareholders, whether they were institutional or not, on one level, and then if
they were institutional, on the other level, made a difference to the
performance of the company. We found some. I would be happy to look for the
reference and send it to you.
Senator Oliver: Professor MacIntosh appeared before us. He also wrote a
background paper and we are familiar with his work and his statistics.
Mr. Schwartz: There does seem to be a link. It is not as strong a link as I
might have hoped, if you collected data and do the studies -- and I believe
that is the way policy in this area should be done. There should be reasons to
do things. The reasons that I found, and I believe Professor MacIntosh would
agree, for us, who think of ourselves as enthusiasts in this area, the research
could be stronger.
You asked me another question.
Senator Oliver: The question of activism of institutional investors and taking
an active role in management and directing management of the corporations in
which they have substantial holdings.
Mr. Schwartz: If you would accept, sir, I do not have a strong view on that.
Mr. Chairman, and members of the committee, I had made the point that I thought
the U.S. is initially moving away from this corporate-style governance model
that came under the 1940 legislation. Something happened quite recently in the
United States. It is in my paper, the Navellier management problem. Navellier
was a money manager of two funds in the United States and he did what we would
call in Canada apparently a related party transaction. He was planning to merge
the two funds. I do not have all the details at hand but that transaction led
the directors of one of his funds to fire him. It was very unusual for a board
to fire the money manager, but they did it. They had the right to do it; they
thought it was the right thing to do.
Navellier then launched a proxy fight. He went directly to his fund investors
and told them that he was acting in their best interests and had a lot of money
for them over the years. Surprisingly enough, he won the proxy contest. So what
we had there was a situation where the fund directors tried to get rid of him
and the investors wanted him back in. The directors went to the securities and
exchange commissioner, according to the reports that I have seen, and asked for
some support. The securities and exchange commission told the directors that it
was their fund, and to handle it.
This is one of the things that is wrong with the United States that is right
with Canada. If that situation had ever occurred in any Canadian province, I do
not believe our securities regulators would have wasted two minutes thinking
about whether they ought to do anything, which in this case was, on the surface
at least, patently abusive.
If we go to the American model in Canada and we give our fund boards, these
directors, the authority to act, and the unit holders do not like it, can they
then go to the securities commission to appeal the directors' decisions? If we
allow that, we have introduced another level of supervision. On the other hand,
we in Canada have adopted a regime of more activist securities regulation than
in the United States, and no one -- and I include Commissioner Stromberg -- has
said that that should be changed. I believe she likes and agrees with the
current style of interventionist securities regulation to protect fund
investors. And so we have a bit of a problem if we now establish boards, because
in the United States they have devolved certain powers from the regulatory
authority, the boards, and so the senior regulator is not interested any more
in some of these issues. I do not believe that that fits with our history; I
see problems with doing it.
If I may make one other observation -- and I would like to admit a certain
embarrassment or lack of facility in these matters because they are ultimately
political. The Province of Quebec, through its consultative committee that I
mentioned earlier, has said that they do not like the notion of requiring
independent fund boards. They want fund family boards, and they do not even
think they must be independent. I ask myself what will happen if the Ontario
commission goes ahead and adopts something like Commissioner Stromberg wants --
and Alberta and B.C. may also do the same. You can imagine what will happen. We
have the scenario of a Quebec-based mutual fund that does not have these
onerous rules in its own province wishing to get distribution across the
country. If that fund comes to the Ontario commission asking be distributed,
the securities commission must reply that the Quebec-based mutual fund does not
meet governance requirements. The fund from Quebec, or its management company,
will then ask for an exemption from the securities commission under the
governance rules in order to get distribution in Ontario.
Under this scenario, the commissioners, in my submission, have an onerous
burden. If they grant the exemption for the Quebec-based fund, all the other
funds that have gone the route of complying will be, let us just say, very
upset. There will be enormous screaming and complaining about how all the funds
have gone to the expense, and it is a significant expense, of complying and then
someone who does not comply gets an exemption.
On the other hand -- and this is difficult for me to speak about -- if they deny
the exemption to a Quebec-based fund they will be taken in some quarters to
simply have added to the list of things that some people keep about how the
country does not work. Some people will say that this is once again an
opportunity for the rest of Canada to tell us in Quebec how we should do things.
That is just an unbelievably difficult situation. I do not believe it should
happen. I do no see any way around it if we go this route and, in the end, if I
have not convinced anyone that on its own merits we should not go that route, I
believe the politics of it are very clear. I would not wish to give people an
opportunity, even in this relatively minor matter, to claim that this is a
situation where the rest of Canada is doing things and ultimately imposing them