Canada's Quantitative Investment Rules – Time For A Change

June 10, 2013

By Michael Nobrega
Published in Benefits and Pensions Monitor May 27, 2013

You tend to notice when a U.S. think-tank praises the pension fund you work for and suggests you may offer a model for U.S. pension funds to study. That was the verdict of a March 2013 report by the Washington, DC-based Center for American Progress. This is one more sign of how Canada's large pension plans and pension fund investment managers – such as CPPIB, the Caisse de Depot, bcIMC, and OMERS – are coming into their own and gaining global recognition.

Like our banks, which have thrived in the face of the 2008 recession, large Canadian pension funds are gaining world-wide stature as investors and as models of prudent governance and administrative efficiency. As always, the first priority for pension funds remains securing the pension promise to its members. To accomplish this, we aim to earn reasonable returns that will exceed our funding requirements.

As hospitable as the environment in Canada has been for the success of our large public pension funds, the regulatory regime has not kept pace with changing times. At the forefront of the regulatory barriers that pension funds face are quantitative investment rules. The source of these rules is federal regulations, but the regulations are incorporated by reference into provincial pension legislation. The key takeaway is that, in their current form, the rules prevent the pension sector from realizing its full potential as a locomotive for active investment.

Rules Once Served Purpose

Are Ottawa and the various provinces enforcing these rules because they are attempting to deliberately punish the sector or hold it back? Not at all. As a matter of fact, there was a period 
when the rules served a purpose, but this was once upon a time, when the pension sector was less professionalized, when fiduciary responsibilities were less well-defined, and when governance standards were not as robust. The rules also reflect a period in time when pension funds were generally passive investors who were reliant on third-party managers, rather than active, direct managers of their own investments.

In addition to the duties to which corporate directors are subject, pension plan administrators are subject to certain duties. For example, Ontario's Pension Benefits Act requires that in the administration of a pension plan and investment of a pension fund, the administrator must use all relevant knowledge and skill that the administrator possesses or ought to possess.

Regulations also require pension plan administrators to establish written statements of investment policies and procedures (SIP&Ps as they are known). This promotes a due regard for risk. Additionally, there are regulations prohibiting self-dealing, transactions with related parties, and other conflict-of-interest-type situations. These are just some of the protections and standards helping to ensure pension plan directors focus their attention on prudent management of their respective investment portfolios in the best interest of their respective plans. Overlaying these protections and standards are necessarily powerful regulators, such as the Financial Services Commission of Ontario (FSCO) and the Office of the Superintendent of Financial Institutions (OSFI).

30 Per Cent Rule

Admittedly, few people are aware of these quantitative 'federal investment rules,' as they are known. One of these rules – the '30 per cent rule' – denies pension funds the ability to have full voting rights as shareholders of public and private companies. As such, pension funds are limited to no more than 30 per cent of a company's voting shares in electing corporate boards. As a recent Wall Street Journal article by Ben Dummett on the 30 per cent rule put it, "A Canadian pension fund may own most – or all – of the equity in a company, but can only vote in board elections as if they own 30 per cent."

Speaking from my professional experience, the 30 per cent rule has been for some time a serious obstacle to execution of any sophisticated investment strategy. In order to comply with the rule, while also pursuing active private market investment strategies, pension funds have no choice but to use highly-complex holding structures. This is done in order to keep the voting and economic interests in corporations separate.

In OMERS case, for example, compliance with the 30 per cent rule for its internal management companies is unduly burdensome. It certainly provides no net benefit to OMERS members and it is hard to imagine a rationale for imposing the 30 per cent rule in this circumstance.

Commercial Disadvantage

There is another cost to the 30 per cent rule. It places Canadian pension funds at a commercial disadvantage with foreign pension plans or private sector investors (both foreign and domestic). This is because sophisticated investors will, to protect their interests in a particular investment, routinely seek more than 30 per cent of the equity in a major asset in order to achieve a proportionate level of control over that asset.

Will the federal government open up a messy, 'Wild West' scenario if it drops the 30 per cent rule? Not at all. As I noted above, there are already regulations and protections in place to prevent this from happening. And if there's fear (far-fetched, in my view) that, absent a 30 per cent rule, large pension funds would begin colluding on mega-takeovers of Canadian firms, the penalties under Canada's Competition Act will handily address that. Furthermore, this view is founded on a fundamentally flawed overestimation of the collective clout of Canada's large pension funds.

What exactly will trigger the phasing out of the 30 per cent rule by federal or provincial governments? I will not venture to guess. One possibility could involve Ottawa's lack of comfort with large-scale foreign takeovers in the Canadian oil and gas sector (as signalled following the acquisitions by overseas interests of Canadian energy firms Nexen and Progress last December). The federal government may need to look at how large Canadian investment pools (including pension funds) can help take up those investments. After all, Canadian pension funds have already collectively invested hundreds of billions of dollars in our economy.

The necessary evolution will come, I have no doubt. This could take several forms. The federal and/or provincial governments could formally suspend the application of the 30 per cent rule to foreign investments for two years, as (to quote Dummett again) Canadian pension funds, venturing abroad "face competition from many big [overseas] funds."

The federal and/or provincial governments could simultaneously study the implications of phasing out the 30 per cent rule for domestic private companies.

Cumbersome Measures

Federal and provincial governments have already demonstrated a keen interest in modernizing Canada's pension sector and removal of these outdated, cumbersome measures fits well with 
these efforts.

In Chapter 3.2 of Budget 2013, Ottawa announced plans to consult provincial governments about "permitting a limited number of qualified persons who are not resident in Canada to serve on the board of directors" of the Canada Pension Plan Investment Board. This is a clear acknowledgment that as the CPPIB invests abroad, its board of directors might benefit from having access to the international talent pool." In other words, the world is changing and the CPPIB cannot be held back by rules that no longer make sense in this era.

I support this change wholeheartedly and it gives me some hope that Ottawa may look at revising other rules which are holding the pension sector back from reaching its full potential.