Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 19 - Evidence - May 13, 1998
OTTAWA, Wednesday, May 13, 1998
The Standing Senate Committee on Banking, Trade and Commerce met this day at 6:05 p.m. to consider the present state of the financial system in Canada (the role of institutional investors).
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: Our first witnesses today are Gerry Rocchi, who is the President of Barclays Global Investors, and Katherine Taylor, Vice-President. Thank you very much for your attendance here.
Mr. Rocchi, do you have overheads with you?
Mr. Gerry Rocchi, President, Barclays Global Investors Canada: We do have overheads, Mr. Chairman; however, we have a handout and we plan to pace through it during our presentation.
The Chairman: That is much simpler.
Mr. Rocchi: We appreciate the opportunity to participate in the policy process. We are also delighted to be speaking to the more experienced group of senators tonight, as opposed to your young namesakes on the ice.
We are the Canadian unit of a truly global enterprise. To put my comments in context, I will give you some background on our organization. Globally, we manage over $700 billion, both as the world's largest index fund manager, where we manage portfolios to precisely track a client's performance target, and as a large active manager using quantitative techniques to structure portfolios that return above the performance benchmark for about $150 billion of assets.
We emphasize several ideas that make sense for investors. We use our scale in indexing to deliver extremely low costs for our clients; we are scientific in giving our clients exactly what they want; and we use our global transaction flow to enable clients with offsetting transactions to trade with one another, minimizing market impact and trading costs for our clients.
In Canada, we were, last year, named the country's fastest growing institutional money manager. We have actually been growing more quickly this year, in 1998, and now are managing close to $17 billion in assets. We have a staff of 26 providing portfolio management, trading, portfolio accounting and client servicing for over 85 clients in Canada.
Our success, we believe, is founded in our philosophy of developing long-term partnerships with our clients. Equally important for us, as Canadian, has been our ability to raise the profile of Canada as a great investment opportunity to our non-Canadian clients in other offices around the world. Over the last two years, our efforts have resulted in almost $2 billion of additional investments in Canada from non-Canadian investors. We have also successfully introduced Canadian suppliers of investment technology to other offices in our global operation.
Lastly, Canadians play important roles in the global enterprise; in fact, they account for three of twelve members of our global management committee.
The next area I will touch on is the role of investment managers. To do this, I will touch on the influence of investment management firms on the economy and on corporate governance. Following that, I will focus a little more deeply on the governance of investment management firms themselves. To do that, I will focus on three aspects: the importance of risk management in an investment management firm if it is to fulfil its client's request, and what it takes to manage risk; the role that client reporting plays in allowing clients to make a fully informed choice, which is a fundamental building block in an effective capital market; and finally, the most dramatic type of difference that can occur between the interests of a client and that of the investment manager -- that is, when the temptation of personal trading or unethical trade allocation interferes with the manager's duty to look after clients first.
These three areas capture many of the important issues in manager governance, and hopefully will serve as a springboard to any questions you have after these remarks.
Let us turn first to the influence on the Canadian economy. Institutional investment firms can affect the Canadian economy in profound ways. Perhaps the most important way that we see is in mobilizing capital for private-sector investment. Investment management firms can provide access to markets in ways that include diversification, liquidity, expert skill and low cost. This low cost and effective access to markets plays a powerful role in motivating institutional investors to supply Canadian capital markets, and hence Canadian companies, with additional equity capital. This contributes to a more efficient capital allocation process in the economy.
At Barclays, we manage money for some of the largest institutional pools of capital in the world. We have been using those relationships, as I mentioned, to substantially boost inward investment into Canada by about $1.9 billion in the last 18 months. We have done this primarily in two ways. We have promoted the potential investments of Canadian investments, which has been very successful, in providing Canadian speakers to different global client conferences. We have also worked with Morgan Stanley to create a new international equity market benchmark, the All Country World Index, which includes Canada. Until now, the most popular, and even now the most popular market benchmark, the Europe-Australia Far East index, or EAFE, does not include Canada, which leads to Canada not being used at all by most international index funds and to lower than normal usage amongst active managers.
As more of our clients and other investors switch to this new benchmark that includes Canada, we expect to see substantially more investment into Canada from our non-Canadian clients. That has already started. We have already been converting some of our clients and we look forward to much more of the same.
Our main method for influencing corporate governance is through voting, for two reasons. As index fund managers, we cannot simply "vote with our feet" and sell a stock when we disagree with how a company is being run. We also act through voting because of our duty to our clients to act in their best interest.
These two motivations lead us to support proposals that allow normal market forces to influence how a company is governed, and we support this approach for all companies in the TSE 300 index, helping to the make the entire market more transparent and accountable on governance issues.
We tend to oppose those proposals that block normal market forces. For example, we will oppose differential voting rights between classes of shares. Another example is that we oppose so-called poison pill proposals, except for those that merely allow for sufficient time for alternative bids to come forward. Staggered board terms are another example of proposals we oppose.
The next area I will address is risk management. We like to begin any discussion of risk with a reminder that risk is multidimensional. The most commonly understood risk, of course, is market risk -- the daily ups and downs of the capital markets with which we are all familiar. Of equal importance is a mechanism to ensure that the investment manager structures the portfolio consistent with the client's guidelines. To use an extreme example, if the client has asked for a large cap Canadian equity portfolio, you should not be buying emerging market investments. That is an extreme example, but less extreme examples can be very costly.
Other dimensions of risk can be significant, in part because they are less obvious. For example, when a broker collapsed in Hong Kong last fall, some investors suddenly discovered the importance of performing thorough credit analysis when selecting brokers. Consider the risk in some countries of not receiving a genuine share certificate in exchange for your money. In one country where we have had a concern of whether or not we should invest there, it was possible to deliver a photocopied share certificate in return for cash.
The Chairman: Sorry, say that again. Did I hear you say what I thought you said, that you could just photocopy it?
Mr. Rocchi: You could deliver a photocopied share certificate in exchange for cash. Before we will commence investing in a company on behalf of our clients, we look at certain risks of the country. Sure, investment risk is important, but we also look at structural legal risk, such as whether or not settlement can be assured -- a bona fide security in exchange for the good cash you have handed over. You may have picked the right stock but it may not be a piece of paper that you can sell.
The Chairman: It may have been sold to several different people.
Mr. Rocchi: That is correct. In Canada, with foreign content rules, what about a manager who has reported the wrong cost of their foreign investments? Or, for a more spectacular example, what about a manager using ordinarily useful derivatives who inadvertently lets leveraged exposures develop?
I could go on for a while with examples and anecdotes. Risk, unfortunately, can come at you from some surprising angles. What is important is a thorough understanding of the skill, expertise and risk management practices of the investment manager. At what level of the organization do risk managers reside; do they have real authority; can they be compromised by the reporting structure; are the risk policies well documented? Simply put, has the manager made the requisite investment and commitment to preserving and protecting his or her clients' assets, because, after all, it is the client's money.
Senator Kolber: I am trying to figure out where you are heading, because so far it sounds like a commercial for Barclays. What I do not understand is, what are we supposed to do about it? Are you going to go come to that?
Mr. Rocchi: What we would like to provide is background for what we think is important in the governance of institutional investment firms. Whether that is something that should be encouraged by this committee in your report, which can be a powerful inducement to either legislation, regulation or self regulation --
Senator Kolber: Are you going to have a recommendation on that?
Mr. Rocchi: Yes. Let me turn to client reporting. Merely reporting the return on a portfolio in a time period is not enough information today. Any investment return that is reported to a client or is advertised by an investment manager begs three critical questions. First, what was the return of the passive implementation alternative for the client mandate? If the client wanted a TSE 300 mandate, their alternative was a TSE 300 index fund, and it is to that return that the return should be compared. Secondly, how much risk was taken relative to that passive alternative? If the manager took on risk different from the passive benchmark, was this risk rewarded? In other words, did it add any extra return? This risk can be described in terms of the difference of the positions of the portfolio relative to the index, even if in any one particular period the return of the portfolio was similar to that of the index by coincidence. Thirdly, was this the only portfolio managed by this manager against this mandate, or only the best of several, and we only are reporting the best of several in this instance?
Without answering these types of questions, the client cannot make informed judgments about the skill of the manager, the manager's discipline relative to client mandates, and the consistency of the manager across portfolios and clients. Without this informed judgment, the whole system of effective allocation of investments is held back by this weakest link in the chain. The critical questions I have posed are addressed by many managers in Canada, but unfortunately not by all. Many managers simply do not provide this necessary information to allow clients to effectively monitor performance.
Senator Kolber: Could you just elaborate a bit? If a investment manager were to tell me that last year he made 25 per cent, I would say that that was pretty good. How does one measure passive and active, and what risk he took?
Do you really go to that much trouble to inform each one of your investors what you did and how you did it, and report to them?
Mr. Rocchi: Yes, we do.Suppose he earned 25 per cent a year when the passive alternative or an index fund earned 32 per cent. In that instance, is 25 per cent really that great? I would suggest that it was not, because the alternative was to have earn 32 per cent.
Senator Kolber: Do you tell your investor that you did a lousy job, therefore rethink us?
Mr. Rocchi: We tell our investors how we did against an external criterion -- where we have done better than the criterion or worse -- and address the sources of the difference with out investors. They deserve to know.
Ms Katherine Taylor, Vice-President, Barclays Global Investors Canada: The institutional world of investing is really quite different than that which we might be used to as retail investors. In the retail world, you see a mutual fund, say, and know that it is a Canadian equity fund, but you do not know what that portfolio's specific mandate might be. Is it designed to outperform the small cap portion of the marketplace? Is it focusing on large cap stocks? Is it really looking at the full, broad TSE 300 index, so in the institutional environment clients establish a complete statement of their investment policies and goals, which includes specific target benchmarks against which every manager within that asset class will be measured? It is like the report card for how well an institutional manager is doing his job, and it is an important score card.
Senator Kolber: Do you have a sample of the report card with you?
Ms Taylor: I do not, but we can certainly arrange to have one sent to you.
Senator Austin: It is how institutions compete with one another.
Senator Kolber: I understand. What I am failing to understand is what are we supposed to do about it?
The Chairman: Why do we not continue and then ask that direct question.
Senator Kolber: We can defer the answer until then.
Mr. Rocchi: I would like to finish the risk management area by turning to one of the most critical issues in portfolio management: that is, managing and monitoring the potential conflict between the interests of the manager and the interests of the client. This occurs primarily in the trading area. The most obvious example involves a manager buying or selling a stock for their own account in advance of, or instead of, the same action for a fund they are managing. A less obvious example would involve allocating good trades -- that is, low-priced purchases and high-priced sales -- to an account with an incentive fee for performance, or allocating the same good trades to a pooled fund where the participants include several of the firms portfolio managers or their relatives and the less attractive trades to the generally available fund. Another example is receiving preferential allocations in an initial public offering from a broker in personal accounts in exchange for less favourable trades done through the client account. Is the manager directing brokerage commission to pay for research or other services provided to the firm, which are rightly the costs of the firm and, if so, are the commissions and prices allocated to the client the best possible?
As you can see, the further you think about the issue, the more apparent it becomes that there are opportunities for inappropriate behaviour, which is hard to detect on the outside but is, in fact, relatively easy to detect within an investment management firm. What counts here are two things: The first is a clear, coherent and meaningful policy of the firm; the second, and most important, is consistent and effective implementation of that policy. It may be a nice-sounding policy, but how is it really followed? Is a log kept of personal trading requests and their disposition? Are trade allocations monitored and reported to senior management? What do they do with those reports? These are all examples of important practices, no matter what the policy is.
I would like to turn to my conclusions, and I will extend the conclusion discussion to include some recommendations. We did not include recommendations in this paper, nor had we initially intended to, but we definitely have opinions on what we would like to recommend.
We believe the important issues of investment management firm governance run into how well a firm takes care of client interests. These issues resonate well with your committee's mandate to examine, as we understand it, if fund management has kept pace with the open and accountable governance practices that have evolved in other sectors of society. Are those interests put first? Are the manager's interests allowed to conflict with those of the client? Trading is the most important element of this. If client interests are put first, has the manager put in place the skilled personnel with requisite authority and senior management support to manage the myriad risks faced by the client? Is the client given the necessary information to make the choices needed to keep our market system well functioning?
I view the subsequent report of this committee, whether it recommends legislation, regulation or self-regulation, or improved practices, to be a powerful motivator. As such, to have a system of effective client choice, investment managers should disclose to the client the passive alternative of whatever was their investment strategy along with the risks taken.
The Chairman: The passive alternative being essentially an index.
Mr. Rocchi: Being the index.
The investment management industry should have a code of ethics, to cover some of the conflicts of interest that I have described here. We believe that enforcement is an important component of that. Without enforcement, we could double the number of regulations or prohibitions, and it would not count for all that much.
In the area of risk management, investment firms should have the risk management policies, procedures and commitments that we have described. In this instance, we think that encouragement of that as the best practice would be a welcome initiative by the committee. Those are the areas of risk management that I have talked about.
We also talked about the role of institutional investment management in the economy. Our major goal there is to point out that institutional investment management benefits the economy by facilitating investment in private companies through cost-effective mobilization of capital. A reminder that anything that can facilitate low-cost investment, alternatives for investors, helps to mobilize capital and thus is good for the country.
Finally, corporate governance. I have explained to you how, as an index fund manager, we feel we must act since the alternative of selling stocks, when we feel the company is not that well managed, is not, philosophically, open to us.
The Chairman: Just so I am clear, acting means voting proxy, is that right?
Mr. Rocchi: That is right.
The Chairman: It does not include doing anything else.
Mr. Rocchi: That is correct. As an index fund manager, we believe, philosophically, that we do not possess any information not shared by others in the marketplace, so we do not act by lobbying with management to pursue a certain strategy. Our influence -- our actions -- is exercised through voting, and what we tend to vote on are governance structures of corporations -- an important role for managers such as ourselves.
The Chairman: My first question is: Given the experience your company has around the world, and given the fact the two of you are involved in a worldwide company, recognizing that you may not know a whole lot of details, what is your overall perception of the government's rules or regulations governing institutional investors in Canada compared to other countries? Are we stricter; are we just non-existent; are we lax? Where do we stand on some kind of international scale?
The IFIC -- Institute of Investments Funds of Canada -- put out its self-regulation guidelines within the last few days. What is your reaction to self-regulation as opposed to a stronger regulatory scheme?
Answer my first question first, because it may have an impact on your response on the second question.
Ms Taylor: It is interesting to look at where we stand in Canada relative to even our nearest neighbour. In the U.S., they have a national regulatory body that oversees essentially the entire securities market, the Securities Exchange Commission. That regulatory body has very broad reaching powers, right up to being able to imprison people. They have very stringent monitoring procedures, which they have centralized nationally. Of course, that does not mean that nobody ever contravenes, but it certainly means that they know that big brother is watching.
In Canada, there are securities commissions across the country, but there really is not a uniform set of regulations, nor is there a central repository into which all the data flows so that the trades can be effectively monitored. As a result, things happen that do not get caught until some lengthy period of time after the transaction has actually taken place. It is relatively easy to do things in different jurisdictions and essentially not get caught.
I would say, if I were to rank us relative to our nearest neighbour, as it comes to securities regulations specifically, we are somewhat behind the times. If we broaden that out to the way that pension funds are managed or institutional investors manage assets, we are much more in sync. The sorts of things that I mentioned earlier -- for example, statements of investment policies and goals -- are very common in Canada. They are really the norm in the institutional world, and that is certainly the same in the U.S. marketplace, and really in most of the developed institutional markets. There, I think we would rank much better, but I would definitely not rank us very high in the area of securities regulation.
Is that sort of where you were headed, Mr. Chairman?
The Chairman: Yes; thank you.
Would you now address the issue of the IFIC and self-regulation, please?
Mr. Rocchi: It just came out two days ago, Mr. Chairman. I will be honest with you, I have not even read it yet. I only know what I have read in the newspaper, so I am only going by memory. I think it is a welcome move in the right direction; however, I would need to read the whole thing. What I read in the newspaper did not cover all the instances that we went over here.
The Chairman: What about the broad principle of self-regulation versus regulation by -- for example, in the federal case it would be the regulator of pension funds.
Ms Taylor: I guess I have been in this industry long enough to be a little bit cynical about human nature. Whether we like it or not, we do have a tendency to be opportunistic. In that vein, it is tough to look at certain opportunities that come along in the investment world and pass them up. Being self-regulating is an admirable thing to aspire to, but I am not altogether convinced that it is something that can really put in place the controls that a truly regulated industry with some teeth to the regulations would be able to achieve.
I will be quite frank. In our daily trading for our clients, we take in portfolios from other managers who have been terminated because of poor performance. I could curl your hair, or straighten it, if the reverse were true, if I were to relate to you some of the things that we have experienced -- and these are portfolios that are run for institutional accounts where you would expect a fair degree of knowledgeable supervision on the part of the plan sponsor, their consultant and the trustee. If that is taking place in the institutional world, where there is that level of scrutiny, imagine what is taking place in the retail world where they do not have the benefit of the knowledge to know what to look for or access to the information.
Mr. Rocchi: To summarize, we are sceptical about self-regulation, if that was what you were getting at.
Senator Di Nino: Just to follow up on your comment. You are saying that, in your opinion, self-regulation is probably the weaker of the two, state regulation and self-regulation. Obviously the other kind is through some government agency.
Mr. Rocchi: Right.
Senator Di Nino: Would you also, then, comment on the need for a national regulatory body as opposed to provincial ones.
Mr. Rocchi: I think there are substantive reasons for a national regulatory agency. Let me mention one of them first, which is how non-Canadians view Canada. Non-Canadians like to think that there is a body that acts on behalf of all of Canada to look after the interests of all investors. No matter how strong or well intentioned the provincial securities commissions, the fact of the matter is that it is a situation that appears to non-Canadians to be weak because of the lack of a national regulator, and credibility is an important commodity in financial markets. There are certainly see several other reasons for having one domestic regulator, not the least of which is cost. Investment management firms and, more importantly, government resources could be better put to use, instead of filling in the same set of forms twelve times, putting those resources into enforcement.
Senator Di Nino: So I gather you support one national commission.
Mr. Rocchi: We support one national commission.
Senator Di Nino: You are a foreign player in the Canadian market, if I understand correctly.
Mr. Rocchi: Yes.
Senator Di Nino: What are the advantages and disadvantages of playing in the Canadian market vis-à-vis your operations in other countries? By the way, how many other countries do you operate in?
Ms Taylor: We manage assets in over 50 countries; we have offices in six. We have to be familiar with the regulatory environment in each of the countries in which we manage assets.
Senator Di Nino: How do you find operating in Canada, managing the assets, vis-à-vis other countries?
Ms Taylor: It can be challenging, in the sense that you are required to comply with so many different sets of regulations, many of which are somewhat outdated, in terms of their response to current market realities, and many of which are conflicting with one another.
Senator Di Nino: One of the purposes of this committee -- I am a temporary member; I am pinch-hitting for one of my colleagues -- I understand is to study financial institutions in Canada. Do you have any specific ideas -- and this is where I think my colleagues were getting to before -- to help us in defining what it is that we do well and what it is that we do bad?
In answering that, you could do give us some specific ideas. For instance, you talked about some of the benefits of dealing with your organization -- and yes, it did sound a little bit like a commercial, which is fine; this is admissible.
Ms Taylor: Let me say that we had a twofold reason for talking about Barclays: first, to establish our credentials; second, because the topic was in part the role of the institutional investor, to give an understanding of the impact on Canadian capital markets of attracting institutional investors from other markets around the world to the Canadian market. We do not need to necessarily have a closed environment to succeed. In fact, that may not be the best thing to do.
With respect to things that we would recommend, one would definitely be a national securities commission. We would also recommend a set of clearly articulated guidelines. There are pockets of legislation governing the investment of pension assets. This legislation can be found in various securities acts and in the Income Tax Act, to name a few. The efficacy of the markets would be enhanced by combining all the legislation into one coherent piece of legislation. In this way, everyone would be able to reference the legislation and would be playing from the same rule book. I think that would be a big plus from everybody's perspective.
We need to send a clear message to the non-Canadian investment community that the securities regulators do have teeth. I do not think we need to tell you about the black mark on Canada's investment copy book that Bre-X placed for non-Canadian investors. The Australians literally laughed at us because they went through the same kind of debacle in the eighties. As a result of that debacle, they put in place specific guidelines governing the criteria to list a company on what is really the nationally recognized stock exchange.
Those are examples of the sorts of things that could be implemented that would make Canada a more welcoming environment, a better place to do business.
Senator Tkachuk: Your brief addressed a couple of the key issues that we have talked about and struggled with in this committee. I have a problem with trading within stock exchanges by brokers and the right of customers to know whether the brokerage firms themselves are unloading stock that they have information on to their clients. I raised this the other day and we had a small discussion on it, and then of course someone said that the broker has an obligation to tell you. I made a number of phone calls today to friends to find out whether any of them have ever received such a telephone call from their broker.
Are there regulations governing that kind of practice, or is it self-regulating, and can people insist on their broker informing them of all the stock that they hold within the brokerage house?
Mr. Rocchi: I have not heard of any regulation around that type of disclosure. There is regulation governing brokers using inside information in a conflict with the interest of their client. Enforcement of that is another question, but obviously some enforcement does go on. However, our sense is that it is not a lot of enforcement.
Again, if you want to compare it to other countries, in the United States, there have been high profile cases where people have actually gone to jail for that type of activity. I have not noticed that here.
Senator Tkachuk: It does not mean that it is not happening here; it is just that people do not go to jail here.
Mr. Rocchi: That is right. It is the case that brokers are supposed to declare whether they are a principal in the transaction or whether they are acting as an agent. They are supposed to. I do not believe it is encoded in the regulations; it may be an IFEC guideline.
Senator Tkachuk: We have had previous pension plan discussions here with respect to the question of having discussions with management about the performance of the corporation. I like your policy, which is that you believe you should not know things that other shareholders do not know. Frankly, not one group yet has said that, which means that they are visiting with them, and they are talking to them, and they do know things that other shareholders do not know. Do you think that regulations should be instituted on this practice?
In other words, do you think there should be regulations to prevent that from happening; that they should just simply vote their proxies, which is legitimate and fair and is a strong influence on what a corporation will do?
Mr. Rocchi: Let me first just clarify. We vote our proxies; however, that does not mean that we think other investors should not speak to management in terms of telling management what they think about their strategies. We vote to ensure that the market for corporate control is as free as possible, so that there are no impediments to it; so that if a corporation is not exploiting all possible opportunities, there are no impediments to someone else buying out that company. We also see no problem with institutional investors having a view as to how a company should be run or the strategies they should follow with imparting those ideas to senior management of the company.
I think your concern is the issue of the flow of information out from the company to selected large institutional investors; that is the idea that is more fraught with peril and with danger. I fully agree with you that that is a dangerous situation. There are regulations now on the books about how companies disclose their information, so I am not sure that more could be done in terms of adding regulation. There is plenty right now about how companies disclose information. If it is significant, if it is material information, it must be disclosed to all shareholders.
Ms Taylor: One of the reasons that we do not necessarily go and make the visits is really more a function of the way we manage assets, because a manager that is seeking to add value above an index, a benchmark, is going to go out and interview various companies to try to confirm his own intuition about those companies. That is sort of part and parcel and ingrained in the investment management system.
As my colleague said, the key control is that the information that is imparted by the companies is the same to that manager that is currently in the marketplace at this point in time.
The Chairman: When you decide to vote against a management proposal, is that known? It seems to me that public knowledge that Barclays, given your name, was opposed to a particular proposal would carry some significant weight, at the very least in the business press, and conceivably with other investors who were contemplating also how to vote their proxy.
Is it known to anybody, other than the people who received your vote, that you have decided to oppose a particular position?
Ms Taylor: It would normally be the case, in the normal course of the voting, that we would probably not broadcast it, but if there were a very high profile issue, such that we wanted to ally ourselves with others with a similar view, then we would very definitely not have a problem putting our name forward.
The Chairman: But generally that does not happen?
Ms Taylor: It rarely happens.
Senator Tkachuk: You oppose staggered boards. Could you just explain that to the committee?
Mr. Rocchi: What we oppose is the staggering of board terms. For example, a third of the board may be elected for a three-year period ending in 1998, a third might be elected for a three-year period ending 1999, and another third for a three-year period in the year 2000. We prefer one-year coterminous expirations of all director mandates because staggered board terms can be an impediment to change of corporate control. Our philosophy is that impediments to changes in corporate control are things, which at the margin, incrementally are disincentives to effective management of corporations.
Senator Callbeck: I just want to pursue the issue of influence in corporate governance a little further. You said that you get involved by voting, and you answered the question as to why. You have now just said that generally you do not disclose how you were voting.
Do you feel that you have much influence on corporate governance?
Ms Taylor: I would say that we do, because we have carefully crafted an articulative proxy voting guidelines, and we hold very large positions in some companies. Because we are a large manager, we are obviously known to management as a large investor. If they wanted to see our proxy voting guidelines, they could certainly do so. It would not be an issue for us because we give them out to all of our clients. As a result, we do have a fair bit of influence on how companies govern themselves.
Senator Callbeck: Do you feel that you have more or less influence in Canada, in corporate governance, than some of the other countries?
Ms Taylor: I would say it is about the same.
Mr. Rocchi: At times, that depends on how large our positions are. We have a larger market share of the U.S. So if it is proportionate to your market share, we would have more influence there. In countries where we have a lower market share, I think relative to market share we have similar influence. Our voting guidelines are known to many and to anyone that wants to know.
Senator Callbeck: Do you think it is true that managers that tend to manage by an index rather than picking the stocks or the investments tend to be less involved in corporate governance?
Ms Taylor: That may be the opinion of some people -- because the managers are not going out and making the type of on-site visits. However, what it really comes down to, in my opinion, is what underlies their whole corporate governance structure, their whole voting policy guidelines, because you can have as much impact by how you vote your proxies as you can by lobbying with management for change of this or change of that. Therefore, I would say it really depends on how detailed you have taken the whole proxy analysis.
Senator Callbeck: Do you think this whole area of institutional activism will increase? How do you feel about that?
Ms Taylor: If the U.S. is any example, I would say the answer is probably yes. CalPERS is a perfect and well-known example. As these pools of capital become larger and larger, the shareholdings also increase in size. Not to criticize anything with respect to foreign content, but it is exacerbating in Canada because more of the total pension assets reside in Canada so that the control issue becomes has a snowball effect. Yes, I think it will increase in the near term.
Senator Callbeck:What are your views on the 20-per-cent rule?
Mr. Rocchi: We certainly believe that Canadians, as would all investors, benefit from the maximum amount of diversification, and that is achieved by being able to invest in other countries. In a country where there is no limit, experience has shown that, on average, people tend to invest, at maximum, 30 per cent to 40 per cent of their assets outside of their home country. We do not think a relaxation of the limit would lead to an enormous rush of capital outside the country, we think it would be more gradual and limited.
Ms Taylor both saw a report by a consultant which listed investing practices in different countries. Only two countries in the world limit how much their tax-exempt or tax-deferred investors can invest outside their country.
The Chairman: Who was the other one?
Mr. Rocchi: South Africa.
Ms Taylor: We tend to forget that this limitation sends a signal to other countries, be it the U.K., Germany, France or wherever, that although they allow their citizens to invest as much as they choose in our country, Canada, we will not do the same they thing. In this era of globalization, if you put aside all of the modern portfolio theory and the efficient market theory, that is not a user-friendly message.
Senator Austin: Would you consider your proxy rights a value that you would sell to some other party?
Ms Taylor: We have never been asked to do that. I would suggest that it is something we would be viewing as somewhat proprietary to the value that we provide to our clients. Therefore, the answer is probably no.
Senator Austin: If it is of value to your clients and you could gain compensation for it, why would the answer be no?
Mr. Rocchi:Obviously, the payment would be to the benefit of the client fund, not to Barclays. There is no question about that. If a pooled fund of ours sold those rights, you must remember that our unit holders are constantly changing, people are buying and selling, so those who benefited from the sale of those rights may not be the same people who are missing the benefit of the voting privilege later on. I am not sure we could ever manage to do that in a fair way.
Absent that, I think we must be confident that we can still fulfil our fiduciary duty to our clients. While it is theoretically possible to do that, I think we would be concerned with how we could do that by having sold the rights, even for the financial benefit of the existing clients. I think we would be so concerned about how he could fulfil that fiduciary duty, we would probably talk ourselves out of it.
Senator Kolber: My colleague asked about inside information and the possibility of regulation, is there not a whole body of corporate law that governs that? I was under the impression that there was. The companies in which I am involved are extremely careful who they say what to.
Ms Taylor: There is a fair bit of law on that, and it usually resides in securities law.
Senator Kolber: Are there bodies of laws which govern that?
Ms Taylor: Yes.
Senator Kolber: Do you agree that there is a different culture in Canada, vis-à-vis shareholder activism? If you attend an annual meeting almost anywhere in United States it may last six or seven hours, and there will be all kinds of people selling investor letters and God knows what. If you attend such a meeting in Canada, it may last 22 minutes and then everyone has lunch.
Ms Taylor: Are you asking if Canadians are apathetic?
Senator Kolber: Yes.
Mr. Rocchi: On the regulatory side, the Securities and Exchange Commission in the U.S. makes it exceedingly easy for individuals to put competing proposals in the proxy circular, as compared to how easy it is in Canada.
Senator Kolber: They make a business out of it.
Mr. Rocchi: I think that is one reason why the meetings are, on average, longer.
Senator Kolber: You said that Bre-X gave Canada a black mark. I am sure it did, but is there any way you can legislate against fraud? Do you think the Toronto Stock Exchange could have enough staff to actually send someone to Indonesia or wherever to see if there is gold there?
Ms Taylor: No, I think the issues really come down to not the expectation that the exchange will independently audit the results of all the companies it lists -- that is obviously unrealistic -- rather, the suggestion is that there be a requirement that prospectus filings be updated more often.
Senator Kolber: What would you do if they kept updating the fraudulent information?
Ms Taylor: I agree that you cannot legislate against that. I believe that, with Bre-X, the prospectus that was repeated filed with the exchange was dated in the early nineties. It was certainly not current relative to the time of the listing.
Mr. Rocchi: Whenever someone is forced to sign a prospectus-level disclosure document, that requires some kind of due diligence which increases the opportunity to catch the fraud, although, if it is concealed well enough, you are absolutely right, we will never catch it.
Senator Kolber: I think it is fair to say the TSE has not been as vigilant as it should have been with back-dooring now. I know they are moving, but they have been a little slow, to say the least.
Senator Austin: I want to explore a question that was raised earlier with respect to self-regulation, as opposed to a government or a parliamentary code. You expressed the opinion that there must be objective standards that are derived from the democratic process of assessing the issues, but would you be comfortable with industry management of that code as distinct from government officials managing that code? Could we leave it with industry management and ask them to report to parliament once a year on the performance of the industry against certain set standards. Is that workable, or do you believe that you need a group of impartial officials who are not of and in the industry?
Ms Taylor: In many respects, it maybe better to have them in the industry, in the sense that they then understand all the tricks of the trade, as it were, and effectively police them. One industry body, the Association of Investment Management Research -- AIMR -- does cover quite a quite a broad number of investment management firms. Anybody who is a chartered financial analyst is covered in their organization by default, and they do have the power and authority granted by the association to assess people and their performance vis-à-vis the code of ethics and professional standards, and deregister them, but all that they can do is take away their professional designation. It does, however, act as an effective deterrent.
Your question concerned whether that should be taken up a level so that you would have an industry body which was sanctioned by the government.
Senator Austin: Yes, the government would create the normative regime, but the people who would run it would not be government employees, they would be employees of that entity. They would run it according to industry standards as set out. The expertise is there and the cost of acquiring that expertise in the private sector has to be at the private sector's market rate. You cannot put a $70,000 official who is not involved in the industry on a day-to-day basis up against someone who makes $300,000 in the private sector and who is involved daily. The first question is: How do you create a regime that works?
The second question is focused on the issue of sanctions. This body could have sanctions that it could apply under the legislation it is administering. Apart from fines and so on, what is the power of the sanction of disclosure incompetence or inadequacy, or falling below certain measures? Are those types of standards effective in governing conduct? Would people pull up their socks if they thought that the investment community would be told that they were not considered very competent?
Mr. Rocchi: First, Credibility and reputation are the real currency in performing a fiduciary service for others.
Second, some specific sanctions are now available to securities commissions so that, when someone has contravened one of the regulations they can be compelled to stop doing business immediately. There are some actual sanctions available now, but the one you are talking about would absolutely work.
Senator Austin: I am not talking so much about personal behaviour because the OSC has just surfaced an illustration of its performance there, but in terms, essentially, of the operation of the business, the back office problems you were referring to, the disclosure issues, so that we could, for example, set up a quarterly report that had to be disclosed. We could require the directors of that particular enterprise to sign it and accept personal liability for its accuracy, and if it turned out not -- I mean, we could raise the bar. How high should we raise it?
Mr. Rocchi: You are right, we can raise the bar. There is also a report that is available that goes some ways towards that. Many custodians and investment management firms go through that reporting process, where an audit is performed on many of the back office functions we have discussed. It requires an independent review; it requires a management letter.
I always liked the idea of having some kind of representation letter from senior management of an enterprise. It holds them responsible in the event that that representation is not true; it puts the accountability where it should be. People think twice before they sign, and they perform their own due diligence.
Senator Austin: Then you get corporate governance that has real teeth because your directors know what their exposure is. We seem to be moving away from softer approaches, in the world of regulating financial institutions, to a more U.S.-type practice, which is up front. "Do not make a mistake, because there will be no soft landing for you." The landing is going to be very hard, and that seems to be psychologically what is required, according to this argument, to make sure that the due diligence is done, that the corporate governance meets standards.
I take it, from what you have said, that you would prefer that system; correct?
Mr. Rocchi: Yes, we would prefer the hard-landing approach. We think it best protects the client's interest. I think you put it well.
Senator Kelleher: I hope I will not put you too much on the spot with this question, but that is not going to deter me. You have told us how your firm deals around the world and the number of countries you are in, and you are obviously very familiar with the capital accumulation and investing in financial institutions. I am sure you are very familiar with banking operations around the world and the globalization that is taking place in that realm.
Right now, four of five Canadian banks are proposing mergers. We have been listening to the arguments of these large financial institutions who tell us that because of globalization, and the difficulties with capital accumulation, Canada is going to have to do this too. In simple terms, they are saying that bigger is better.
What is your opinion?
Mr. Rocchi: In general, I would say bigger if necessary, but not necessarily bigger.
Senator Kelleher: Can you elaborate on that, please?
Mr. Rocchi: I would look to the facts and circumstances of each situation.
Senator Kelleher: I am dealing here specifically with Canada and the four banks involved in these proposed mergers.
Mr. Rocchi: Yes, and I am sure that the four banks themselves are well placed to explain what the benefit is to Canada.
Senator Kelleher: We would need an independent opinion from somebody who will perhaps have to invest in these institutions.
Senator Austin: But first of all you have to establish how large Barclays is.
The Chairman: Substantially bigger, am I correct, by a lot?
Mr. Rocchi: That is correct. Banks are an amalgam of businesses; they are not one business. For some of those businesses, scale matters; for other parts of their business, I am not so sure that that is true. The idea that banks can afford to take on more diversified and broad risk in their lending activities and thus be a more effective intermediator of capital for the country is unquestionably true.
The idea that banks, because they are larger, can afford to invest in more businesses is interesting, but is mostly for the benefit of the shareholder. So some of the arguments for size work; some of the other arguments for size are primarily for the bank.
Ms Taylor: I would add that obviously there is a corollary competition issue. If we go from four big banks to two big banks, or three, then we obviously run into the issue of how that serves the Canadian citizenry. I would suggest that one of the ways to combat that, which the bank themselves are probably not terribly keen on, is to open the borders and level the playing field a little bit to make it more attractive for others to come into the marketplace to serve the Canadian people, and hence keep the competition alive, shall we say.
Senator Kelleher: Let us assume for a moment that, for whatever reason, the mergers did not go through. Do you think there would be resultant damages to Canada? Forget the banks for a moment, that is a different story, but thinking now of Canada as a country: Would it hurt Canada if mergers such as this did not proceed?
Mr. Rocchi: I believe that initially the financial markets would be negatively impacted because it would be hard for the rest of the world to understand why a consolidation would not be a benefit to the country on a net basis. They would be concerned that the reason for the merger not coming together was a barrier to consolidation and efficiency that would then be a long-term detriment to the earnings prospect and its financial markets. I think that would be the initial suspicion of financial markets.
Senator Kelleher: And in the longer term?
Mr. Rocchi: In the longer term, I guess it would depend on why such a merger would not take place.
Ms Taylor: I would add that it would also be a function of how the market continued to operate. If we stay with the status quo and assume that the markets remain closed to foreign banks coming in, then I think we can expect that we will be less well served as Canadians because we will potentially pay more for our banking services than might otherwise be the case if there were a more free and competitive environment.
Senator Stewart:We are told that one of the important results of the EMU will be a rationalization of banking in Europe, and that the rationalization will not be confined simply to the banking industry, but to almost all other financial institutions. Given Barclays global experience, is there room in Canada for a considerable rationalization of our financial intermediaries; and second, should we not consider the possibility of a North American rationalization?
I ask the second question because the Standing Senate Committee on Foreign Affairs was told last night, by an authoritative witness, that one implication of what is happening in Europe, the move to a common currency, may very well be a move for common currency in North America.
Could we really improve the economy by getting rid of a lot of these surplus bankers and so on? We were told that 50,000 people are going to be out of jobs in Europe.
Mr. Rocchi: I would just like to note that even without the idea of their being a North American currency, the Canadian and American economies are becoming increasingly integrated, to the point there is not a lot of difference.
Senator Stewart:I was talking about banks, for example.
Mr. Rocchi: Right. We are talking about maybe going down to three large banks in Canada, and that is not too many. As Ms Taylor said, from the competitive aspect we only have three alternatives. That is not a lot. If you are displeased with the service of one, that leaves only two to choose between. I, for one, would like to see more than three suppliers of financial services to Canadians. Ms Taylor alluded to the idea that an amelioration to some of the concerns about the concentration of banking is to open up the competition.
I do not believe that Canadian financial institutions or intermediaries overall have an excessively high cost base which is being passed through to financial services consumers.
I do not see any evidence which suggests that Canada is suffering from a top heavy, unwieldy, costly financial services engine which is being foisted on its consumers.
The Chairman: Let me thank both of you, Mr. Rocchi and Ms Taylor, for taking time out of your busy schedules to be here.
Our next witness is Mr. Michael Grandin. Please proceed with your opening statement.
Mr. Michael Grandin, Executive Vice-President and Chief Financial Officer, Canadian Pacific Limited: Good evening, senators.
If it meets with your approval, I will make some introductory comments directed at the three questions included in the material that was sent out.
The Chairman: That would be excellent. Inevitably, we will ask you to expand on your ideas, and we can go from there.
Mr. Grandin: I am sure everyone here is familiar with Canadian Pacific, so I need not go into the background of the company. However, since we are talking about institutional investors and their interest in large companies, I would just say that in the last Financial Post survey that I saw, Canadian Pacific ranked sixth, excluding the four major banks, in terms of market capitalization in Canada, or tenth if you include the banks. Needless to say, Canadian Pacific is a big company with a lot of history. The company is well known in Europe and in the United States.
By way of my personal background, I was a senior officer of Dome Petroleum at the time that company went through its downfall. I have spent over six years in the investment banking business and been through several mergers, acquisitions and restructurings. I was Chief Financial Officer at PanCanadian when we went through what I might call the "rejuvenation stage", That was a pleasure. I was the Chief Executive Officer of Sceptre Resources when it was sold.
The Chairman: You worked all sides of the street.
Mr. Grandin: With respect to your question regarding the extent of influence that institutional investors have in the Canadian economy, as I understand the question, you are looking primarily for some statistics in that regard. Canadian Pacific's market capitalization today is approaching $15 billion. Approximately 340 million shares are outstanding, and it is trading around $43 or $44, so there is large market capitalization. The largest shareholder owns less than 10 per cent. I believe S.C. Bernstein & Company owns 9.8 per cent. The shares are widely held. Approximately 87 per cent of the shares are held by institutional investors, and 13 per cent are held by individuals.
Fifty-two per cent of the shares are held in Canada; 44 per cent are held in the U.S.; and the balance are held by other foreign investors outside of North America. The 25 largest holders of Canadian Pacific shares account for 50 per cent of the shares. People who analyze the investment community tend to classify investors, and I believe their finding would be that, of the 25 largest holders of Canadian Pacific, 17 would be classified as long-term or low-turnover investors, meaning that they would plan to hold their investment for a minimum of three years; five would be moderate-turnover investors, which would mean that they plan to hold their shares for 18 to 36 months; and the remaining three would be high-turnover investors.
Our shareholder base tends to be longer-term investors, perhaps more value oriented than growth oriented, and are less influenced by some of the weekly and quarterly variations in the company's earnings and reported results unless, of course, they consider that some of those results are indicative of a longer trend.
As I am sure you are aware, Canadian Pacific went through quite a major reorganization starting in 1994. The company exited five businesses, restructured its entire capital base, and focused its efforts on its remaining five business, and we did that under the intense scrutiny of institutional investors. You might have expected a very large turnover in the company shareholder base, and in fact there was a large turnover in the number of shares. In 1996, when the actual reorganization was taking place, the trading volume was over 90 per cent of the common shares outstanding. Having said that, though, if you go back to 1994, which is just before the reorganization, 14 of the 25 largest investors in the company today were also shareholders then. They have different holdings, but they are still fairly significant shareholders of Canadian Pacific, so we have had quite a stable institutional base.
Notwithstanding that, our annual average trading volume is 75 per cent of the shares, so there is a lot of liquidity in the stock. A lot of trading takes place at the various edges. That will give you a sense of the type of participation.
From a pension-fund and a mutual-fund-holding perspective, these statistics tend to get a little confusing. As I said, S.C. Bernstein own almost 10 per cent of the company. As a manager, they manage funds on behalf of a very large number of pension funds, individuals, and so on.
The sum of both the pension fund holdings and the mutual fund holdings of Canadian Pacific form the largest pension and mutual funds in North America. They total about 22 per cent of the shares, a fairly small number. Approximately 9 per cent of the shares are held by the top 10 Canadian pension funds, and about 3 per cent by the top U.S. pension funds, and those numbers are reversed when it comes to mutual funds, with about 6 per cent being held by the top 10 U.S. mutual funds and about 4 per cent by the top Canadian mutual funds.
That indicates to us that share ownership is increasingly being represented by a fairly concentrated group of professional managers whose performance is being judged with increasing frequency on the basis of how well they do relative to their benchmarks and relative to their peer group.
As was mentioned in the earlier discussion, we would agree that the newer investment managers have fewer ties, if you like, to corporate Canada. That means many new managers are more likely to take the aggressive tack, less likely to back away because of inner corporate relationships.
They are also "for profit" organizations which are under a lot of pressure to differentiate themselves in the marketplace. There is an increasing ability and motivation, I suppose, to become more active amongst the institutional community. Their interests do still tend to be focused on stock price, which is fairly short term and not necessarily the best indicator of management performance.
As to your question of how these institutions exert their influence, I believe, even based on the material you sent out, that the institutions would fall into three categories. One is those who do, in fact, vote with their feet. There are still lots of them around. Another, and there are a larger number of them, are those who do try to engage in dialogue with companies, and persuade managements of their views. The final category, which is fairly small now but it seems to be growing, is those institutions which will actually buy enough shares, seek a board seat and try to take what I would call "catalytic action" to make changes in the corporation.
We have had no experience with the latter group. You see it more in some of the other companies around the country now, particularly troubled companies such as MacMillan Bloedell and Moore Corporation.
With respect to the institutions that vote with their feet, their influence is felt indirectly through the impact they have on the stock price. I will not spend much time on them.
I will discuss the middle group who want to spend time talking. We find that the representatives of these institutions are very well informed and have done a thorough analysis of the company and its peer group. They are also familiar with all the rumours. They tend to offer advice, suggestions and recommendations focused more on short-term financial optimization as opposed to long-term strategic planning and allocation of capital. It is often difficult to differentiate between what is genuinely being offered as advice, and what is being tabled as an attempt to elicit information from management that will allow them to be better informed than their competitors in the marketplace. It is difficult to assess their motives.
If we were approached by only one such institution which expressed some fairly strong views, it would be most unusual that they would have much influence on our actions unless they uncovered something which we had overlooked. In that instance, we would correct our own assessment. It would be most unlikely that it would have much of an impact. If, however, similar views were expressed by a significant number of large shareholders, then that might have an impact on our actions or, alternatively, it might affect how we disclose and describe our plans to the public.
It may be that we do not think they have understood what we are doing well enough, or it may be that they are raising some points that we ought to carefully consider. One of the interesting elements is that, although management is responsible to shareholders through the board of directors, what you have is direct feedback and interaction with the shareholders going on outside of the board forum, and that strictly between management and the shareholders.
Related to that topic, in some of the materials you sent, you asked about proxies. We have not undergone any sort of proxy challenge at CP. We have not seen any particular attempt by outside managers to influence the day-to-day activities of the company or the day-to-day management of the company. When it comes to inside information, people have or pretend to have lots of information, but I would say, from all the interaction I have had, that investors, if they have inside information, are not coming to us very often. At least in my experience they have never come to me with what obviously is inside information.
Some of them do, as you know, have board seats. Some senior partners in some of the institutional investment firms have seats on boards of corporations, and those that do have internal controls presumably deal with that. A large number of institutions basically just refuse to allow it because of the obvious conflict it raises, at least from a perception point of view. That is all I can say on how they exert their influence.
Your last question had to do with how institutional investors are themselves governed. I am not in the funds governance business, but Canadian Pacific Limited does have one of the oldest, largest pension funds in the country. It was started in 1902 and it was turned into a trust into which the employees could make contributions in 1937. It is $5-billion in size today. It is internally managed on an active basis, not on a passive basis. It is a very mature fund. I believe two thirds of the assets are allocated to retirees. We have had larger out-flows than in-flows, that is, the contributions are smaller than the disbursements, going back to 1984. In many respects, it is an interesting plan.
We view our pension fund as a business with assets and liabilities, revenue and expenses that have to be managed, and with return objectives that have to be met. We govern the fund through the board of directors. The board of directors has established what we refer to as a "pension trust committee" which goes back to the days when it was a trust. Their function is to set investment policy, asset mix and performance benchmarks. That committee meets twice a year to review policy and performance against the benchmarks, as well as to review the balance sheet.
There are two subcommittees and another group. The first subcommittee is what we call the "pension committee". The pension committee is comprised of management, labour and pensioners. Its role is twofold. First, it is largely administrative, that is, it looks at how the benefits are administered, what happens to the surplus and matters such as that, and, second, it is a mechanism for communication between management and the various stakeholders in the plan. They also meet twice a year to discuss those issues.
We also have what we refer to as a "policy committee", which comprises senior management of Canadian Pacific and some of its subsidiaries. Its role is to work with the internal pension fund manager, to provide some advice on capital markets to assist the fund manager, and to work through his recommendations on asset mix, investment policy and instructions to managers. That committee meets with the manager every two months.
We also have a group which we call the "pension fund manager", which is comprised of 15 to 20 individuals. As I said, they manage actively as opposed to passively. They, basically, run the money. They make all the buy and sell decisions under their own guidelines and committee approval systems. Their compensation is tied to performance measures. We have benchmarks established for the various categories that we invest in, and that applies to the managers, including the president of the pension fund. A large part of their compensation is based on performance against those benchmarks, and the time frame for most of them is split between short-term performance, which would be the one-year performance of the fund, and four years, which seems to be a standard adopted in the pension industry.
We do vote our shares and that is done, generally, in line with guidelines suggested by the Chartered Financial Analysts, many of which were mentioned by the previous witnesses.
Historically, corporate pension funds tended to go easy on other corporate clients or companies in which they invested. That is perhaps a little less true today, although we do vote against management quite often. However, I do not believe we would, at this stage, ever take an active role in initiating a dissenting movement. If we felt strongly about something, we would probably vote against it, along with others, but we would not solicit competing votes.
In conclusion, we think that the increased level of feedback we get from institutions, even the more aggressive ones, is useful and very important. Notwithstanding the fact that this information is flowing to management outside of the board process, we would never make a material response to it by way of changing our actions or the company's direction without having it thoroughly reviewed and discussed at a board meeting. Generally, from our perspective, the system seems to be working. We certainly would not be looking for any increased regulation in these areas.
The Chairman: Thank you, Mr. Grandin, for a most interesting overview.
You commented on institutional investors where some of the managers sit on boards. You did not say you did not think it was a good idea. However, you did refer to the "obvious conflict of interest" which can exist in those situations. You assume that the institutional investors have a way of handling that. I would infer from that comment that you would probably favour a situation where institutional investors were not represented on boards, is that fair?
Mr. Grandin: There may be a better way for me to answer that question. If it were me I would feel very uncomfortable, if it were my fund, sitting on someone else's board, and having access to all the information you get at a board meeting. I know from the few funds with which I am familiar, and with the personalities involved in them, that the senior members of the firm do take an active role in investment decisions. It is almost impossible that they do not. I would just be uncomfortable.
As to whether it has any impact on us, I do not think it has any particular impact on us.
The Chairman: You also talked about the short-term orientation of many institutional investors, and as you point out, that happens because the managers of the funds are compensated on the basis of short-term performance. That is disturbing in the sense that, if you are running a pension fund you should have long-term investments, not short-term investments.
Mr. Grandin: That is right.
The Chairman: On the other hand that is not an unreasonable response by managers to the incentive situation in which they find themselves. There is probably nothing that one could do about that apart from changing the incentive scheme. It seems that there is a problem when people who are investing in pension funds want long-term stability and the orientation is in short-term return. There is no link between that desired goal of the pension fund and the pension fund manager's personal compensation. If I am right, is there anything one can do to get them back in sync?
Mr. Grandin: I do think this is a structural issue. If your pension fund is managed by outside managers, then you judge your external managers against their peer group. If the peer group is being measured by how they did against the TSE 300 over the last twelve months, that is how you will measure your manager, and you will hire or fire them over a four-year period. In fact, we measure our own people on the same basis. You have to decide whether you want to keep your internal managers, go to an external manager, or go to a passive manager.
It is a very difficult issue. Incentives work, and in this case they are working well. If you take too long a view you can do a lot of damage in the short term. Certainly, when you drive home from work and hear the mutual fund report everyday at five o'clock, you begin to wonder about people's investment horizons.
The Chairman: Given the fact you are one of the few major Canadian companies with significant U.S. institutional investors, and that is because of your size, your history, your U.S. holdings and all kinds of things, are you noticing any different behaviour in the way institutional investors in the U.S. approach you, what they ask you to do, the amount of dialogue they have with you, and so on. I think there is, at least in some quarters, a greater sense of activism over apathy. Someone referred to it as the "Canadian way". Do you notice any difference between the U.S. institutional investors who come to see you and their Canadian counterparts?
Mr. Grandin: There is not a lot of difference between the institutions. They take the same level of interest. A U.S. institution that has a high level of interest and wants to engage management in a fair amount of dialogue about what they are doing and what they think they ought to be doing does not take a different approach from a Canadian institution. Some of them are, perhaps, a bit more aggressive, but Canadians have a similar philosophy. What I would say, is that there are more U.S. institutions take that kind of an interest. They want to meet with management one-on-one.
The Chairman: There are more of them of them in an absolute sense, obviously, because there are more pension funds. Are there more pension funds in terms of the percentage?
Mr. Grandin: I really could not comment on that. In terms of the percentage of investors in Canadian Pacific, there would be a higher percentage, yes.
The Chairman: When they come to see you, what do they want?
Mr. Grandin: They want to talk about any subject in which they can engage you. The most topical issue for CP at the moment, given the comments that our chairman has been making, is which business we are going to sell and when. They will discuss matters such as that. Our company has moved from a situation where we had a lot of outstanding debt and were fairly highly levered, to a situation where we have a fair amount of cash and a very strong balance sheet, with the capability of conducting some fairly large transactions if we wish. Therefore, there is an increasing number of inquiries and suggestions as to what we should do with our money. They will ask, "What are you going to do about PanCanadian in a low price environment?" They ask general business questions. As I said, it is hard to distinguish between a question that is designed to be a constructive dialogue and one that is really just designed to elicit more information out of management.
Senator Di Nino: Your pension plan is internally managed.
Mr. Grandin: Yes.
Senator Di Nino: You have no relationship with professional money managers from that standpoint.
Mr. Grandin: We think ours are professional, but they are internal.
Senator Di Nino: That is a good comeback. Is your relationship with external money managers, those groups of people who both lend and manage money, restricted to those who invest in your company?
Mr. Grandin: That is correct. Our money managers would interact and have discussions with their colleagues in outside professional money manager firms.
Senator Di Nino: You do not hire an external manager to manage a component of your portfolio.
Mr. Grandin: That is correct.
Senator Di Nino: When these money managers come to see you, the potential investors, who do they see?
Mr. Grandin: I have only been at Canadian Pacific for a fairly short period of time. Mr. David O'Brien, our Chief Executive Officer, takes quite an interest in our investor relations program. He usually meets with them. We also have an officer who is responsible for investor relations who carries on the day-to-day dialogue. A large institutional investor will have one, two or more analysts who study the company and do all the background research and work, so they will be phoning the company on a fairly regular basis to get updated information, making sure they understand the public statements and the numbers in the quarterly press releases. Those two gentlemen will typically meet with them. When large institutions want to meet with a company of our size on a one-on-one basis, they usually want to meet with the CEO.
Senator Di Nino: The information that is provided to this institutional manager will be what is available on the public market?
Mr. Grandin: Somebody raised the question of laws covering insider information, and there are lots of them. Guidelines were recently put out by the TSE on disclosure. Their aim is to tighten up how information is disclosed to investors to guard against giving a person information inadvertently. We are very cautious about that. While we are willing to talk about most subjects we will not provide any information that has not already been disclosed.
Senator Di Nino: You may explain it, answer questions, but not provide any information that is not already in the public domain.
Mr. Grandin: That is right.
Senator Di Nino: That is different from an institutional investor who would have a seat on the board.
Mr. Grandin: That is correct. Anyone who is on the board gets all the board materials, for one thing, so there is a very large amount of confidential information that goes out to board members. Any board member has the right to talk to whomever he or she wishes within the company to get answers to questions.
Senator Di Nino: Do you have a code of conduct, code of conflict, or both?
Mr. Grandin: Yes, we do.
Senator Di Nino: Is it a public document?
Mr. Grandin: I do not know if it is.
Senator Di Nino: Is each board member be provided with a copy?
Mr. Grandin: Yes, and every employee is given one as well. That would be public. I do not know about the board book.
Senator Di Nino: It would be interesting to have an answer to that question so we would know if others are following the same procedure.
Would both these institutional investors be treated equally? Would the beneficiaries of the investments that they make receive equal treatment through information provided by a company like Canadian Pacific? If one is on the board and one is not, obviously there would need to be a very strong solid code of conduct or conflict of interest rule that would govern the behaviour of those on the board. Do you have this kind of an animal on the board right now?
Mr. Grandin: No, we do no.
Senator Di Nino: So you cannot really answer.
Mr. Grandin: No, I cannot really answer that. Probably the most important Chinese wall, if you wish, would have to be inside the institutional investor because, as you know, directors who get information are governed by a certain code. When they go back to their various organizations they have to be careful.
Senator Di Nino: Do you find that some of the institutional investors try to get information from you that would not normally be available in the public domain?
Mr. Grandin: Always.
The Chairman: How easy is it for you to get hold of most of your beneficial shareholders? I ask the question because BCE's Red Wilson made the point that some astronomical number like 75 per cent or 80 per cent of his shareholders were Canadian Depository Securities shareholders. He did not know who they were. Looking at your data I get the impression you have a much better knowledge of who your shareholders are than he does. Am I right and, if so, what is different?
Mr. Grandin: I do not know if you are right. Some of the larger institutions do not seem to mind disclosing their holdings. You will find that most of our shares would be held in CDS just because it is a book system, and much easier to effect transfers of stock.
The Chairman: Certificates do not have to move around.
Mr. Grandin: You can still own your shares in a book system, or CDS, and have the company know who you are as a shareholder, and how many shares you have.
We subscribe to a service, as I think most large companies do. We use Georgeson & Company, out of New York, who specialize in investor relations. They go through all the public documents, and talk to all the institutions to find out who owns how much of what stock. They do not have all the answers. We would know, for example, that Sanford Bernstein has 9.8 per cent of Canadian Pacific, and that they are running money for maybe a 100 or more different funds, but we would not know who all those people were. We would not know who all the beneficial owners were, other than those who have disclosed their position.
The Chairman: The reality is that you may know the middle man, to be Sanford Bernstein, for example, but you would not know the actual beneficial shareholder.
Mr. Grandin: We may not.
The Chairman: And you may not even know who Sanford Bernstein is, except, in this instance, he is big enough for you to know.
Mr. Grandin: Yes, I do not believe there is any requirement that they must disclose their name to us.
The Chairman: Some CEO's expressed the view that it would be helpful to them to know who the beneficial shareholders were. Would that be helpful to you, purely for the purpose of be able to communicate with them?
Mr. Grandin: From that point of view it would be. I think most of the shareholders who want you to communicate with them communicate with you. CP typically does not, but smaller companies may ask one of the large investment dealers to arrange some meetings in, say, Toronto or Montreal and there will be representatives of various institutions at some of those meetings. They may or may not let you know that they own the stock. They may or may not start up a dialogue.
We thought it might be handy to compile a list and decide who you want to talk to. Is it really important? Probably not. Would it affect how we run our business? I do not think so.
Senator Stewart: At the end of your presentation you were describing the Canadian Pacific pension fund, and you said that the manager's performance is measured against predetermined benchmarks, such as the TSE 300, both over a one-year period and over a four-year cycle. Earlier, when you were talking about the influence of institutional investors on large Canadian companies you paraphrased the following statement from your brief:
Most of the newer institutional investors have fewer ties to individual companies, are "for profit" organizations in their own right and are under pressure to distinguish themselves from their competitors. Their ability and motivation to influence corporate direction is increasing. Their focus is on stock price performance which is not only short term but not always the correct measure for management performance.
I think it is obvious why they are motivated as they are, but I want to ask about the other words you used. You talk about their "ability" and their "motivation". The implication seems to be that, when juxtaposed with the words, "the correct measure for management performance", in a sense they are diverting or distracting, if they are influential. The implication of the word "ability" is that they are distracting or diverting management from the long-term health of the corporation and the long-term health of the economy generally. Is that correct?
Mr. Grandin: As I tried to say earlier, yes, their focus is certainly on the short term. When I talk about one year and four years, those are typically pension fund guidelines. If you are talking about mutual funds, they are quite short-term focused.
Senator Stewart: What about their ability?
Mr. Grandin: I am sorry, when I wrote "ability" I was thinking of the fact that there is an increasing number of managers who are gathering more and more shares so, as a group they are more able to influence.
Senator Stewart: How do they exert this? You say they talk to you or someone in your organization, and they get explanations about information which is already in the public domain, and presumably, therefore, requires no explanation. How do they exert their influence?
Mr. Grandin: When they meet with us they are happy to share with us what they think we should be doing. As I said to you before, unless a very large number of them were saying the same thing, they would not have much influence.
Senator Stewart: My problem is with your word "ability". The implication is that somehow or other, perhaps not with your corporation, but with other corporations, they are effective. The reason I am asking the question is that, in some cases, as I said earlier, they may well be diverting a corporation from its proper goals, or in general terms they may be having a deleterious effect on the economy as a whole. We sometimes read that one of the reasons the German economy was so effective for decades after the war was that they were able to take long-term goals and build for a good future.
Mr. Grandin: Perhaps the easiest way to explain this would be by way of example. Take the medium-size oil and gas companies, because that is an industry with which I am familiar. It is also an industry that raises a huge amount of capital on a regular basis. The institutions that were providing a lot of that capital, investing in these companies, had determined that, if you were to be successful in that business you would have to be able to show significant growth in reserves and production, year over year, make fairly aggressive forecasts, and be able to meet them. Because there was such a consensus amongst the institutions who invest in those companies, they drove a large portion of the industry to actually do that, because if they did not do that they would suffer badly in the stock market. A management team would probably end up losing its job or having to relocate its company. I am sure you read the renaissance statement at their annual meeting this year, saying that maybe this was not such a good idea, and that maybe we should be focusing on a more stable rate that will see us through the longer term.
I do not know that it is necessarily bad to be focused on short-term results. I think it can be bad if you are only focused on short-term results.
As I said earlier, if you are just focused on the long term, things can going terribly wrong in the intervening period, but I think that is a manifestation of the ability and the focus on stock price because, basically, these funds were running, oil and gas mutual funds. They were having to show quarter-over-quarter performance and so they were trying to do much as they could to force the companies to deliver to the extent that they could.
Senator Tkachuk:I have a few general corporate policy questions. How many directors does Canadian Pacific have?
Mr. Grandin: We have 12 at the moment.
Senator Tkachuk: Do you think it is important that they own stock in the company?
Mr. Grandin: Can I give you my personal answer, or do you want a CP answer?
Senator Tkachuk: You can give me both.
Mr. Grandin: I think CP's answer is yes, they believe they should own some stock.
Senator Tkachuk: Do they?
Mr. Grandin: I think most of them do, if I am not mistaken, but do not hold me to that. It is a matter of public record. I am on a couple of boards myself. and there is increasing pressure, particularly in the U.S., for directors to own shares. From my personal point of view, I do not think I will be a better director because I own shares or because I do not own shares. I am on those boards because I think I can make a difference, a contribution. I have some experience that might be relevant. I happen to like the industry and like the company.
Whether I own $10,000 worth of stock or $50 worth of stock is probably not going to make much difference in my performance, but there seems to be a very large body of public opinion that wants to see higher levels of ownership amongst directors. Certainly in the U.S. there is a big movement towards setting minimum share ownership levels and paying directors fees in shares until you reach those levels. I would not be opposed to that. I just happen to think that a good director is a good director, and whether you force him to buy some shares or not.
Senator Tkachuk: Do you create options for your directors as well as your management?
Mr. Grandin: I do not know.
Senator Tkachuk: Are they given options?
Mr. Grandin: I would have to look that up. All the employees have them. All the senior employees have them. The boards I am on have them. I think they have them too.
Senator Tkachuk: Do you think stock options are a good thing?
Mr. Grandin: I think so. It is contingent compensation based on stock price performance of the company. I think it is useful.
Senator Tkachuk: When options are granted in any company, do you think they should be short term or long term? In other words, should they have fuses of 12 months, 18 months; or 5 or 10 years?
Mr. Grandin: I think they should be long-term options. In the oil business they are typically 10-years and the shortest would probably be five years. Usually they have vesting periods associated with them so the options would vest over a three-to-five-year period. You would have to be there a reasonable period of time to earn them, but the objective is to provide a longer-term incentive to get boards and senior managements to think about the longer-term impact on the company of what they are doing. I certainly think longer rather than shorter is preferable.
There is enough pressure to make decisions that are focused on the short term without having options there.
I do know that in the U.S., and you are probably well aware of this, there is an increasing movement to have the exercise price of the option change over time, move up over time, or alternatively have the trigger price; so you might get your options at today's price, but you will not earn those options unless the stock price gets up to some higher level.
Senator Tkachuk: If you create more shares you dilute shareholder value.
Mr. Grandin: That is the negative side. Quite a few oil companies which reported very low general and administrative expenses did so by paying reasonably low salaries and by giving very large stock option awards, which has turned out to be fairly expensive for the shareholder over the last four or five years.
By and large, I think options are good. They certainly provide a financial incentive. The term of the option I think is appropriate, given the type of decisions these people are supposed to make.
Senator Tkachuk: I tried to find some information on this, I was unable find any. If options are given to directors, they become valuable, of course, if the share price goes up. There are a number of ways share prices can go up. One is that the company actually performs well, the market believes it performs well, and thinks it is a good buy because of the job that management and directors are doing.
Another reason is that there is strong demand for the stock. We have, as you know, legislation to set up a large Canada pension fund. Pension plan funds are growing in huge dollars amounts, and we just heard that Barclays has grown by $17 billion since 1992. That is phenomenal growth. Many institutional investors that are not necessarily traders, but they hold stock, some for five years, some for three years and some are short term. My fear is that these huge blocks of cash can create demand.
It would be in the interests of a director to create a demand for CP stock so that he could cash in his options and make a lot of money. Whether the director is doing his job well or not, has nothing to do with it, it is the pressure that can be put on by all this cash in the marketplace for a limited amount of free-floating stock. That is why I asked you the question about the option.
I like what you said earlier about the fact that they have to cash them in at a certain date; that prices go up, but there is no illusion. Are you concerned about that? Do you think there might be a strong incentive for a director to misbehave or perhaps take advantage of knowing a large institutional investor with a lot of cash to spend, by being indiscreet about any deals or proposals that may be coming forward such the acquisition of a major corporation? That is a concern of corporate governments in Canada because we have such a small marketplace, as well as the 20 per cent rule.
Mr. Grandin: Generally, it is not a great concern to me. The reason I say that is, most of the directors I have come in contact with, and admittedly it is a very small sample, tend not to exercise their options until they are ready to retire or leave off the board. There is always an exception to every rule, and you may know some who have huge numbers of options who might be motivated to do something that they might not otherwise do. Typically, the number of options most directors would have would be significant, but they would have other financial assets.
They have their reputation to be concerned about, so I do not think that creates an incentive to do anything that is nefarious in any way. As you say, it takes a big demand to move a stock price very much, so the ability of an investor to influence the government to fund its Canada pension plan obligation, would not be great.
The flip side of that argument is also true. There are many incentives for people to buy stock, such as the great markets we have now, but what sometimes tends to be forgotten is that, when the markets go the other way, it can be a major disincentive to investors.
When Dome got into serious difficulty, those who had large investments in stock, margined some of the stock. It created a huge disincentive and got in the way of a lot of very important work that needed to be done. People were, frankly, frightened to death about their own financial circumstances. It is a bit of a two-edged sword.
Senator Tkachuk: Do you think the reporting time for insider sales or purchases of stock is appropriate. Someone mentioned that it was 40 days. With today's technology, immediately the deal is done it could be on the web. It is important for other shareholders to know immediately if an insider is selling his stock at a rapid rate. Forty days seems to me to be a long time. Do you think that should be changed?
Mr. Grandin: I see no reason why it could not be done. I am sure it is an administrative issue. I do not know for a fact, but it must go back to the days when forms had to be filled out. I cannot see any reason why it could not be shortened. I would be inclined to agree with you, it is important information, that should be available quickly.
The Chairman: One last question, which is almost philosophical in nature, but I am intrigued by your comment, which I know to be true on the basis of my own experience, that virtually all feedback to management from shareholders comes directly from the shareholder and not through the shareholders' representatives on the board. Does that not mean that the underlying principle of boards has either disappeared or, at the very least, is being eroded? We set up boards to represent the interests of shareholders, but when shareholders adopt a particular view, they never bother to go to their representatives, they go to management directly. One has to ask: Is there a role for the representatives of the shareholders that the shareholder cannot fulfil directly? I ask the question philosophically, in the sense that it does seem to me that whatever has happened in the evolution of corporate life, one of the underlying premises seems to be disappearing.
Mr. Grandin: I have thought about that too. My first inclination was to agree with what you have said. However, I would point out two things. One is that managements are not going to do anything with the information they get from shareholders that would materially affect the direction of the company, without discussing it and getting board approval to make a change in the direction of the company. In that context, at least in my mind, it is perhaps not very different from management gathering information on all sorts of things that affect the company; the business, the outlook for the industry, where the competition is coming from, all of which is discussed and debated, and any decision made is made at the board level. In that sense, on reflection, I thought it may be appropriate.
The other matter that is important to point out is that, from my recollection of the investment banking business, and others do it as well, if you are not getting what you want from management and where you think there is a conflict, you can go and talk to a director. Boards, I think, do play an appropriate role.
The Chairman: They become the "court of appeal".
Mr. Grandin: Possibly, and they would be if there is disagreement amongst shareholders on what should be done.
The Chairman: Has that happened in the companies you have been with? I do not mean CP specifically, but you were with Sceptre in interesting times, when major shareholders went to the board rather than management.They perhaps approached management first, but then they went to the board.
Mr. Grandin: It is fairly common in a takeover situation.
The Chairman: Or a sale situation?
Mr. Grandin: Yes. Whether there is or there will not be is not a perceived conflict with management. Often an institution that wants to precipitate something, or an intermediary that wants to precipitate something, will probably go and talk to the chairman, if he is a non-executive chairman, or another member of the board, just to make sure it gets to the board in the form that they wish it to.
The Chairman: And that management does not just screen it out.
Mr. Grandin: Right. I do not think that it is in any way usurping or diminishing the role of the board. I think what it means is that the board is there for the really important issues, and for the less important issues management can deal with it.
The Chairman: Thank you very much for taking the time to come east and be with us.
The committee adjourned.