1. The Nature of Institutional Activism
2. Making Views Known to Corporate Management
3. Institutional Investor Representation on Corporate Boards
THE PIAC, ACPM, AND OSFI GUIDELINES
PIAC, which represents 47 public pension funds and 78 corporate pension funds, recently released guidelines for the governance of pension funds(Appendix 3).
The model is based on the belief that a corporate governance structure is centered on the pension promise and that a pension fund’s primary objective is to manage assets to meet liabilities. The governing body has a fiduciary duty to the plan’s beneficiaries to ensure that the pension promise is fulfilled. The selection of people for the governing body is critical. Each must be knowledgeable, be willing to accept the responsibilities of fiduciary duty, and be independent of management of the pension fund.
The model sets the basis on which the trustees share responsibilities with those responsible for active management. It also highlights the importance of monitoring to ensure that the objectives of the funds are being efficiently met and that the structure maintains its effectiveness in allowing the plan to meet the pension promise.(33)
Further,
…the trustee is responsible to the stakeholders of the pension fund, not to the interests of the organisation. Therefore, all the decisions are made in terms of rates of return and ensuring that beneficiaries receive their money. The interests of the corporation are not included in their decision-making.(34)
The ACPM also issued a report on governance of pension plans last year. (Appendix 4) ACPM emphasizes that it is not possible to design a "one size fits all" model for pension plan governance.
Furthermore, OSFI has been involved in efforts to help regulated entities, including pension plans, understand principles of good governance. It has recently published "Guidelines for the Governance of Federally Regulated Pension Plans."(Appendix 5)
There are common principles contained in these three sets of guidelines:
- a mission must be established and clearly understood by all who are involved with the fund;
- objective performance measures must be established for all key decision-makers;
- the roles, qualifications, and responsibilities of trustees and management should be clearly spelled out;
- those responsible for plan governance should have the knowledge that would enable them to make informed decisions;
- independent trustees should play a key role in the pension governance process;
- the trustees’ duty of loyalty to the plan and its beneficiaries must be paramount over the interests of the organisation that appoints the trustees and of any other parties;
- the principles of pension governance should not vary with the size or type of plan.
The Committee agrees with PIAC, ACPM, and OSFI that these are critical elements of plan governance.
Many funds follow the basic principles set out by PIAC and ACPM. As a specific example, the Committee was told that:
The board of directors of CN has the fiduciary responsibility to ensure that the pension fund is well managed and that the funding policies are appropriate to pay the pension benefits that are incurred by the years of service of the employees, and these are actuarially estimated. The Canadian National Railway Company is the administrator of the fund. The board has established a subcommittee of the board of directors. That subcommittee also has senior executives from the company who oversee the investment division of the corporation, and the investment division on a day-to-day basis manages the assets of the pension fund.(35)
A number of witnesses cited the Ontario Teachers Pension Plan Board (OTPPB) as a model of a well-run plan.
I do not think it is incidental that one of the best governed pension plans in this country is the Ontario teachers` pension plan. It is one of the few public plans of which I am aware anywhere in the world that has achieved crystal clear clarity about what is the real pension deal. It is a 50/50 partnership.
There is an estimated normal cost for the plan, which is about 16 per cent of pay. It is quite a rich plan and fully indexed. If going forward the investment results were not up to the expectations that were used to calculate the funding, there would have to be a top-up. There would have to be more money put in. That is the at-risk question.
The 50/50 partnership in the case of Ontario teachers means that the contribution rates of the taxpayers and of the teachers go up by the same amount. It is a clear risk-reward, symmetrical relationship between the two part partners.
A lot of other public sector plans have not achieved that clarity.(36)
The CEO of this fund identified three elements behind the successful governance of the plan:
- a board made up of individuals with expertise in pension matters or investment;
- a clear purpose, to pay pensions;
- independence of the directors from management.
Basically, the OTPPB follows the PIAC model of governance, a model it helped to develop. In addition, they have tried to follow the recommendations of the Dey Committee. Pension plan members are given an annual report which contains the same kind of information that public companies provide.
OMERS has
a very clearly defined investment strategy, a surplus investment strategy, a surplus management strategy, objectives for funding. We sit back and talk about it. (37)
As noted in the ACPM survey, there are pension funds that do not have a strategic plan, that just react and do not clearly look at their pension plan and assess its needs and objectives.
PIAC, ACPM, and OSFI have issued governance guidelines to encourage those institutions they deal with to take a more systematic, coherent and transparent approach to operating their funds.
Witnesses from ACPM reiterated what many told the Committee.
There is a long way to go before one can say that all pension plans are well governed. The regulators should encourage this interest and also encourage good practices. They must resist, however, prescriptive solutions.(38)
The Committee is cognizant of the magnitude of change that has occurred in the pension fund industry. It views current awareness of the importance of good governance, and more importantly, of the emergence of governance guidelines by a number of organisations, as a significant development.
It was, however, made clear to the Committee by many witnesses that there is still considerable room for improvement, particularly by the small and medium-sized plans.
When the Dey Report on corporate governance was released four years ago, the Toronto Stock exchange (TSE) decided to make it a requirement for all TSE listed companies to file public documents showing how they are complying with the guidelines for corporate governance put forward in the Report. If a company chooses to not comply with the Dey Report guidelines, it has to state why in a public document. The choice to actually comply or not to comply is up to the company.
The result has been dramatic. For TSE listed companies, the threat of criticism by shareholders and the media for not complying with the guidelines of the Dey Report is significant. In effect, peer group pressure and the fear of public embarrassment has made the measures prescribed by the the Dey Report effective.
Should a similar approach now be used in Canada with respect to institutional investors, both pension funds and mutual funds?
One governance expert, who testified before the Committee stated that the potential for public disclosure and embarrassment can certainly lead to a change in behavior. In fact, fear of negative publicity, he felt, is often a stronger incentive to change than publicity itself.
It is the view of the Committee that peer group pressure, and the fear of potential embarrassment if a company’s information is sub-standard in relation to the competition’s information can have a marked impact on institutional investor behaviour. Fear of embarrassment can be a very strong regulatory tool.
The Committee favours an approach similar to that which evolved with respect to the Dey Report on corporate governance. The Superintendent of Financial Institutions described how this might work. He was in favour of an approach
to require the trustees to write a report, setting out how they comply with each of these guidelines; in essence, allow them flexibility to use their own criteria in deciding how they apply. They would have to make a statement similar to the following: "We believe we comply with the guidelines because of the following factors..." It may be less than perfect, but it would give us the opportunity to see the holes in our own guidelines, the areas where clarification is needed. At the same time, it would get the process moving early, rather than waiting until we are really in a position to provide the specificity that will ultimately be necessary to give you a high degree of confidence that people are governing their plans well.(39)
The Committee views the recent attention to the governance of pension plans, and more particularly, the development of guidelines for the governance of pension plans, as positive developments. While the Committee would now like to move more directly to the Dey approach, it recognises that this is an area in which improvements are being adopted rapidly. Many pension funds need more time to decide how to apply one of these sets of governance guidelines to their individual circumstances. Further, there are a number of relatively small, employer-initiated, pension plans, for which the Dey approach may impose such a magnitude of costs, that the employers may move to eliminate the pension plan rather than incur the costs of the Dey approach to governance guidelines. Consequently, it is the view of the Committee that moving immediately to impose a regulation which would require all pension plans to report annually to their members on how the guidelines were being met is not desirable at this time.
The, however, sees a need to encourage the adoption of governance guidelines by all pension plans in Canada, and intends to hold hearings in the year 2000, to determine whether regulations are needed to ensure that plans are being well governed, or whether voluntary compliance with the various guidelines has proven satisfactory.
At some later point, after pension plans have taken steps to improve their corporate governance practices in line with one of the sets of guidelines, it will probably be useful to refine the PIAC, ACPM and OSFI sets of guidelines further into standards.
Recommendation
The Committee recommends that the trustees of each pension plan in Canada above a specific asset threshold to be determined in consultation with plan stakeholders adopt one of the PIAC, ACPM or OSFI guidelines and report annually to pension plan members setting out how they comply with, or exceed, the adopted set of guidelines, and explaining why they do not comply if they choose not to do so. Implementation of this recommendation should proceed once the three organisations are prepared to provide assistance to their respective stakeholders who need guidance on how a plan is to perform self-assessment.
THE GOVERNANCE OF MUTUAL FUNDS
Mutual funds, as was noted on page 3, are very different from pension funds. The mutual fund industry has argued, on the basis of the relative ease of entry and exit of stakeholders, that the market effectively monitors mutual fund management. Witnesses did not, however, feel that pension funds and mutual funds should be treated differently from the point of view of governance; that is, they should be treated similarly from the point of view of scrutiny and evaluation in the public interest.
Ms. Glorianne Stromberg, author of the report entitled Regulatory Strategies for the Mid-90s – Recommendations for Regulating Investment Funds in Canada, (commonly known as the "Stromberg Report")(40) put forward her views on the need for improved mutual fund governance. Released in 1995, the Stromberg Report identified areas of concern with respect to the mutual fund industry and made a number of recommendations that, if implemented, would create a corporate-style scheme of fund governance. Among other things, the Stromberg Report made proposals for improved mutual fund governance including:
- the enactment of an investment funds statute to provide a common statutory framework for the constitution and governance of investment funds; and
- provision for independent boards at the management level and at the fund level .(41)
One mutual fund manager stated:
The funds should have directors who look after the interests of the unit holders in the funds. That is one of the recommendations Ms. Stromberg made.
We are a public company. We already have independent directors. Our mutual funds fall under the umbrella of our corporation. We have that, and think other companies should have that as well.(42)
Another manager added:
The addition of independent directors which have at least some overseeing governance function is an issue that is coming. Many of the companies ... are now putting in place independent directors who are separate from the company and separate from portfolio management. They can ensure that objectives are being maintained.
.... prospectuses must include all of the different objectives of our portfolios. If there is any overweighting in any sectors, the risk attendant to that overweighting, et cetera, all the different fees and summary of expenses are fairly detailed. There is a fair bit of regulation. It is becoming much more transparent to investors.(43)
Not everyone agreed with the need for more attention to the governance of mutual funds. Mr. Lawrence Schwartz presented arguments against implementing a corporate-style governance regime for mutual funds in Canada. He maintained that there are no compelling reasons for adopting such a regime and contended that proposed reforms are driven by suspicion about non-standard, unincorporated investment vehicles. Mr. Schwartz argued that there has been "no demonstration of unit holder abuse in Canada and certainly none that independent boards uniquely could have prevented."(44) He felt that the Canadian regime, which combines regulation and fee structures, provides adequate incentive for fund managers to act in the interests of unitholders.
Mr. Schwartz was of the view that the adoption of governance structures similar to those currently operating in the United States could lead to more litigation and additional regulation.(45) He also foresaw problems with implementing change and felt that to be effective, governance reform measures would have to be accepted nationally; something that he felt would be difficult to achieve.
The Committee did not find the views of Mr. Schwartz persuasive. The Committee believes that there is a need for the implementation of a corporate-style governance regime for mutual funds in Canada. The recommendations that follow reflect this view of the Committee.
Recommendation
The Committee believes that independent directors have a key role to play in the governance of mutual funds. Their independent status leaves them free to focus on issues of fairness, conflicts of interest, and procedural and monitoring issues. Independent directors would not be there to second-guess the investment decisions of portfolio managers. Every mutual fund should be required to have a majority of independent directors.
In her testimony, Ms. Stromberg pointed out that for tax reasons most mutual funds in Canada are structured as trusts rather than as corporations. She went on to note that there are few legal restrictions on the content of trust documents establishing the trust(46). Mutual funds that are structured as corporations, however, are subject to both the statutory provision of the relevant corporate legislation and the body of law applicable to corporations. Noting that there is well-developed legislative precedent for business trusts in the United States, Ms. Stromberg felt that it would be advantageous if business trust legislation were enacted in Canada.(47)
The Stromberg Report elaborated on this concept.
Recommendation
The Committee recommends the enactment of legislation that would recognize a business trust structure that would be similar to a corporate structure and would include provisions for directors and officers of the trust and the extent of their independence, how they may be elected and removed, how fundamental changes in the trust would be made, and unitholders’ rights and remedies.
Recommendation
Investors are entitled to know the risk management and governance practices of their mutual fund manager. They have a right to know what processes are in place to monitor the decisions taken on the risk exposures of the mutual fund, and if that monitoring is taking place.
When the Toronto Stock Exchange Committee on Corporate Governance in Canada (the Dey report) was released four years ago, the Toronto Stock Exchange (TSE) made it a requirement for all TSE listed companies to file public documents showing how they are complying with the guidelines for corporate governance put forward in the report. If a company chooses not to comply with the guidelines, it must state why.
With respect to the governance of mutual funds, if the fund manager is a publicly traded TSE company, it is subject to the Dey guidelines. Other fund managers have no such formal responsibility.
The emphasis in the Dey guidelines is on full disclosure. It is the view of the Committee that the same degree of disclosure should apply to all mutual funds in Canada. The Dey Guidelines should be adhered to by all mutual fund companies in Canada.
INSTITUTIONAL INVESTOR ACTIVISM
The investments of institutional investors have grown significantly since the mid-1970s when pension and mutual funds had only $5.3 billion invested in Canadian equities. Today, the figure is more than $180 billion.(48) One witness told the Committee that this growth reflects two significant developments: the ageing population; and the shift of pension fund assets from fixed income securities into equities.
Pension and mutual funds now own nearly one-half of the shares in Canadian publicly traded corporations; institutional holdings were just over 10% as recently as 1988, and 20 years ago, they were less than 1%.(49)
This dramatic growth in institutional investments has been accompanied by a steady increase in the involvement of these institutions in corporate issues. A decade ago, institutional activism in Canada was almost unheard of. Institutional investors who were unhappy with corporate management or the direction of a particular company would simply "vote with their feet" by selling their shares. Today, institutions no longer automatically follow this path; they possess considerable proxy voting power and may quietly or openly seek the changes in a corporation which they believe should be implemented.
1. The Nature of Institutional Activism
In the United States there is a long history of institutional activism by public pension plans. Mr. Murray Davidson, a specialist in the area of corporate governance practices to both the mutual fund and the public pension plan sectors in the United States, told the Committee that
the activities of public pension plans have been an important catalyst for changes in the corporate governance practices of U.S. public corporations. He also noted that there has been a significant improvement in the financial performance of companies in which major public pension plans have focused attention on the companies' corporate governance practices.(50)
CalPERS, the California Public Employees Retirement System, for example, has been particularly active in corporate governance. Its corporate governance principles cover such issues as composition of the boards of directors of corporations, the relationship between the board and management and the number of independent directors. Finding that many corporations were not receptive to its attempts to discuss the need for changes to their corporate governance practices, CalPERS adopted a more aggressive, publicly oriented stance that includes the creation of guiding principles of corporate governance and the targeting of companies that underperform. Mr. Davidson felt that CalPERS’ public approach to governance has changed corporate behaviour. (51)
Professor Jeffrey MacIntosh, who has written extensively on the role of institutional investors, points out that institutional investors in Canada have shown their influence by:
- voting against management;
- threatening to exercise dissent rights;
- suing to enjoin a transaction;
- enlisting the support of securities regulators to stop a transaction;
- publicly expressing dissatisfaction with management, or on a particular course of action it recommended;
- mounting or participating in a proxy battle to unseat management;
- supporting institutional organizations such as the Pension Investment Association of Canada (PIAC);
- creating proxy voting guidelines dealing with matters such as poison pills, executive compensation and other matters;
- meeting with management, either individually or collectively, to discuss matters of concern(52)
As well, Professor MacIntosh has outlined a number of reasons why institutional investors may not always be active and effective monitors of corporate activities, including:(53)
- free-ridership – the efforts of institutional investors to increase corporate value will benefit other shareholders and may benefit the institution’s rivals;
- co-option by management – the pension plan of a service provider may vote with management for fear that if it does not, it will lose the corporation’s business;
- pension managers may follow a "golden rule" – a mutual back-scratching arrangement under which fund managers appointed by management from one corporation will refrain from engaging in activism in return for similar behaviour from other fund managers;
- political pressures on public pension funds – pension funds may be pressured to make certain investments to support the local economy or for other political reasons;
- limited monitoring capabilities, given large portfolios, limited staff, and limited ability to engage in active management activities;
- the need or desire to maintain liquid portfolios, which results in the acquisition of small blocks without significant voting power;
- legal restraints on institutional monitoring activities;
- an institutional culture of "passivity";
- fear that approaching other shareholders with concerns about management will trigger a "race to exit" which will cause the share price to fall;
- potential fiduciary conflicts between maximizing fund value and corporate value when fund managers become corporate directors;
- the proliferation of non-voting shares in Canada;
- difficulties in identifying other shareholders;
- poison pills .(54)
Some commentators contend that Canadian institutional investors ought to take on an increasingly important role in corporate governance issues. Murray Davidson pointed out that the larger funds are now more active in trying to bring about changes in corporate governance, the structure of board of directors and the number of independent directors. He characterized the approach of Canadian institutional investors to activism as "less public and maybe less confrontational" than that of some of the U.S. public pension funds.(55)
One witness argued that because Canadian institutional investors invest in fewer companies, it is not necessary for them to adopt the CalPERS model of targeting companies.
CalPERS has to monitor … 3,000 companies when they get into their world arena. It is absolutely huge. So they need to take an approach using a screen to focus on a smaller number of companies that they can deal with.
In Canada, a number of institutional investors only choose 40 or 50 companies so they get to know those companies much more intimately. Their screen is used to select the corporate issuers in which they invest. They do not need to use the approach that CalPERS is using, which is the screen to select the targets for shareholder activism. The Canadian institutional investors are looking more at their whole portfolio to see where they are happy with the way the corporation is being managed, its governance structure, or to see areas in which they should be doing something.(56)
Responding to the question of how institutional investors exercise their influence, Mr. Michael Grandin, Executive Vice-President and Chief Financial officer of Canadian Pacific Limited (CP), noted that there appear to be three broad categories of institutional investors: "those that vote with their feet; those that seek to influence management through dialogue and persuasion and a small but emerging group who actively seek to influence management through board seats and catalytic activities."(57) His comments were confined to CP’s experience with institutional investors who use dialogue and persuasion.
Mr. Grandin characterized the institutions that contact CP as being well informed; however, their views and suggestions tend to be short-term oriented and focused on financial optimization. The company often finds it difficult to differentiate between suggestions intended to influence its thinking and those intended to elicit new information.(58) He contended that it would be difficult for one institution, no matter how large, to have a material effect on the company’s thinking; however, if similar views were received from several institutions, "the aggregate effect may affect our actions or may affect our assessment of the market’s likely response to our plans and prompt a change in how we describe our plans to the market and how we respond to questions."(59)
2. Making Views Known to Corporate Management
The Committee heard considerable evidence that the most common form of institutional investor activism consists of private meetings with a corporation’s senior management, usually the chief executive and chief financial officers. Only when this "quiet diplomacy" fails do institutional investors adopt a more public approach.
The Chairman of Sceptre Investments, presently the fifth largest pension fund manager in Canada, told the Committee that private meetings with companies are a valuable tool.
…[W]e have private meetings with companies in which we invest. These meetings are valuable to us, in part, because we control the agenda and, in part, because it is important to us to know the character of the people managing the companies that we invest in. It is important to the companies, and they agreed to do it because they need to keep in touch with their shareholders and we are, typically, a big shareholder.(60)
For the Ontario Municipal Employees Retirement System, quiet negotiations with a company are the most effective way to bring about change. OMERS does this by first seeking information about its concerns and asking how management is meeting the goals and objectives of the shareholders.(61) It described the actions it may take to voice its dissatisfaction when it believes that long-term shareholder value is threatened by a company’s perceived behaviour. In the absence of a decision to sell the shares, OMERS might:
- write to senior management to express its concerns;
- seek a private meeting with management or the board of directors;
- support other shareholders by voting for motions that they have put on the ballot;
- put motions on the ballot itself, or
- engage in legal action against the company whose management is generally believed not to be acting in the best interests of the shareholders. (62)
OMERS believes that "a perfectly legitimate role of an informed shareholder is ... to ask management what it is that they are or are not doing that is generating value for shareholders – particularly when a company’s performance has become misaligned with the shareholders’ expectations. "(63) This, according to OMERS, is very different from telling management how it should run a company or generate objectives.
The Ontario Teachers’ Pension Plan Board stated that, where it has exerted quiet influence", it has acted mainly through the corporate board of directors to improve long-term shareholder value.(64)
In a 1997 presentation to the Canadian Bar Association, the General Counsel of the OTPPB stated:
A third way in which we apply our corporate governance policy is through face to face meetings with the directors and executives of major companies. These private discussions provide an occasion for us to express our expectations as owners about the importance of enhancing shareholder value.
We consider face-to-face meetings with management an integral part of our due diligence is selecting companies for major investments and managing those investments in the long term.
…we are professional investment managers committed to one overarching goal – to create shareholder value for the beneficiaries of our pension plan. Having intimate chats with CEOs is one way of achieving that. (65)
Mr. William Dimma, who is a director of several public companies, believes that the preferred way for institutional investors to make their views known to a company is to deal "quietly and privately" with the CEO and senior officers. He contrasted this quiet method with the more public, and in his view, less effective approach employed by some institutional investors in the United States.(66)
…it should only be a last resort when the pension fund manager or the head of the fund … has to go to the street. There are times when it is quite justified to go to the street or go to the media and give a speech which makes some highly controversial and critical remarks about a company…That is not the Canadian way. That is not the way to get things done.(67)
Indeed, a 1994 Conference Board study, Company Relations with Institutional Investors, confirms that institutional investors prefer to talk to a company’s CEO or other senior officers when they have a serious question.(68)
One witness felt that there was no difference in the approach taken by Canadian and U.S. institutional investors who contact Canadian Pacific Limited except that some of the U.S. institutions may be somewhat more aggressive.(69)
Another witness who serves on the Teachers’ Pension Plan Board in Manitoba, considered it part of the exercise of fiduciary responsibility to have the fund’s investment manager visit companies in which the plan invests.(70)
3. Institutional Investor Representation on Corporate Boards
One of the least utilized methods of activism is direct involvement on the board of directors of a corporation. Indeed, there is considerable debate about whether institutional investors should be directly represented on corporate boards. Conflict of interest and potential fiduciary problems that might arise when an institutional investor becomes an "insider" have been cited as reasons for avoiding institutional representation on boards. On the other hand, improved company performance and the ability to bring concerns directly to the board table have been cited as arguments in favour of institutional representation.
One witness suggested that where institutional investors have large holdings, in the order of 10 percent or more, institutional representation on the board of directors would enhance corporate governance.(71) Another witness, however, felt that it would not be a good idea to have mutual fund managers or pension fund managers sitting as directors of companies in which they have significant investments.(72)
The institutional investors who discussed the question of directorships told the Committee that institutional investor representation on corporate boards was far from common. For the most part, specific board representation is granted only where substantial investments or the purchase of private companies are involved.
In 1997, the General Counsel of the OTPPB indicated that only on rare occasions would the OTPPB suggest candidates to a corporate board’s nominating committee for consideration as directors.
… [W]e will suggest candidates if a company has too many directors related to management. Or if it lacks board members with expertise in areas important to the company’s future, such as knowledge of overseas markets. Or … if the chairman or board nominating committee actually seeks our advice and help. We maintain a book of prospective candidates who are well known to our senior management or our directors.
This process is very much at arms’ length. We put names forward and leave it up to the board’s nomination committee to do the rest. Generally, the relationship is at arm’s length because we believe that a director should be accountable to all shareholders and not to his or her sponsor. Consequently, we do not want nominees reporting back to us. We do not want a special relationship.
The only exception to this rule is in a few companies where we are a major investor in a new business plan, with perhaps 25 percent or more invested in that company. In these rare situations, having our own representative on the board enables us to better monitor implementation of changes that are a condition of our investment.(73)
The President and CEO of the OTPPB stated that, in cases where the OTPPB purchases a private company, it will have representatives on the board, but will relinquish its seats within two years of the company’s going public.(74)
A representative of the Manitoba Teachers’ Pension Plan indicated that where the Plan has substantial direct investments in corporations and real estate, it will take an active role in attempting to improve corporate performance or the operation of a real estate development; this would include taking a seat on the board of directors, if necessary.(75)