Blinding Me with Science

aiCIO reports:

Some fund managers are purposefully bamboozling pension fund investors, who are struggling to see the bigger picture when allocating capital, industry experts have claimed.

Some asset management teams wilfully talk at too high a level when touting their products and services, panellists at a roundtable discussion in London on pension fund governance said today.

While some asset managers may attempt to “purposefully bamboozle” trustees, they may also blind trustees with science through the overproduction of information that is perhaps easy to understand from a manager’s comprehensive view of the portfolio’s performance but may not be of much value to trustees with limited expertise and a more narrow understanding of the meaning of the performance data.  As John Ilkiw has noted in a World Bank publication, “the performance reports used by most boards to monitor and evaluate investment returns and investment risk generally provide too much data and too little information–and what information they do provide is usually misleading because of an excessive focus on peer-relative performance.”  This problem is exacerbated by the “ever-decreasing cost of computing power, which is making easier and easier the production of reports, exhibits, and diagrams.”  He believes that one way to cut through this problem is to focus on simpler questions: are the plan assets being prudently managed, and are they being profitably managed?

Along those lines, some of my takeaways from Institutional Investor‘s excellent Global Sovereign Funds Roundtable (see Ashby Monk’s post here) are that having robust data management systems in place is crucial, and that funds should put a lot of thought into presenting information in a clear way for the benefit of both managers and trustees.  Pension plans and SWFs would be wise to try to do what the SEC is trying to achieve with its XBRL interactive data initiative: providing end-users of data with more tools and more control over how the information is presented so that they can manage data rather than feel buried by data.

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Emptying Oklahoma's EDGE Fund

Tulsa World reports that “the roughly $170 million endowment of Oklahoma’s EDGE (Economic Development Generating Excellence) is being emptied to meet some of the state’s obligation to match contributions to the Oklahoma State Regents for Higher Education’s endowed positions program.”

I don’t take this as a bad result because states have often been ineffective at development investing.  As my colleague Dale Oesterle has written, development funding and subsidies are often a siren’s trap for state and local governments because they rarely provide enough return to justify the expenditures (although Oklahoma’s EDGE apparently did well).  The issue that stood out to me in the article, however, was the fact that the Oklahoma government had the ability to drain the fund whenever it chose to do so.  This contrasts with the legal status of most state permanent funds and endowment funds, which are constitutionally protected.  Here, for example, is the language from Wyoming’s constitution:

Article 15, Section 19.  Mineral excise tax; distribution.

 The Legislature shall provide by law for an excise tax on the privilege of severing or extracting minerals, of one and one-half percent (1 1/2%) on the value of the gross product extracted. The minerals subject to such excise tax shall be coal, petroleum, natural gas, oil shale, and such other minerals as may be designated by the Legislature. . . . The proceeds from such tax shall be deposited in the Permanent Wyoming Mineral Trust Fund. The fund, including all monies deposited in the fund from whatever source, shall remain inviolate. . ..

Inviolate, as in you can spend the interest, but you can’t touch the principal without a change in the Constitution of the State of Wyoming.  As I discuss in a white paper on state permanent funds, voters have shown a surprising resilience to the temptations to draw down on permanent funds even if their legislators would have liked to do so. The issue came up in 2005 in Wyoming when the Wyoming Attorney General issued an informal opinion that only the severance tax portion of the Permanent Wyoming Mineral Tax Fund was untouchable.  Subsequently, a House Joint Resolution called for a constitutional amendment specifying that “all monies deposited in the Permanent Wyoming Mineral Trust Fund are inviolate permanent funds of the state.” The original language of the Wyoming constitutional provision creating the PWMTF was vague, stating only that the “fund shall remain inviolate.” The proposed amendment (eventually set in the Constitution as shown above) sought to clarify that “[t]he fund, including all monies deposited in the fund from whatever source, shall remain inviolate.” In the 2006 general election, voters overwhelmingly—by a 3-1 margin—approved the proposed amendment.

If states want to protect funds for future uses, constitutional provisions are the way to do it.

CalPERS' "Focus List"

Last week I commented on CalPERS’ engagement efforts, and although I do not always agree with the substance of the governance recommendations, I do find them to be refreshingly transparent in their general policies (as does Ashby Monk, although he notes some “cognitive dissonance” in CalPERS’ statements on its investment policies).  Here’s a little more background from CalPERS’ webite on how the fund engages with companies:

CalPERS corporate engagement process has the overarching objective of improving alignment of interest between providers of capital and company management. It is CalPERS view that improved alignment of interest will enable the fund to fulfill its fiduciary duty to achieve sustainable risk adjusted returns. There are three main drivers in the corporate engagement program:

  • Financial Performance – company engagement to address persistent, relative value destruction, through the Focus List Program;
  • Values Related Risk – material environmental, social and governance factors, such as reputational risk , climate change, board diversity and key accountability measures such as majority voting;
  • Compliance – in response to State or Federal legislation, such as Iran and Sudan Acts calling for divestment, which CalPERS mitigates as a risk via engagement.

CalPERS engagement activity is market wide, which can be considered as a strategy for improving the quality of beta in the portfolio. CalPERS also has company specific engagement, which can be viewed as a strategy for addressing alpha related risk. Compliance is a requirement and mitigates both financial and reputational risks for CalPERS.

What I find most interesting in this is the distinction between “alpha” activism and “beta” activism.  The “beta” activism reflects the understanding that CalPERS is, to use Hawley and Williams’ term, a “universal owner“.  Hawley and William’s basic thesis is that “because of their extensive diversification of ownership, fiduciary institutions have become “universal owners” with a significant stake in a broad cross-section of the largest publicly traded firms in the economy. Forced to evaluate portfolio-wide effects of individual firm actions, these institutions have a quasipublic policy interest in the long-term health and well-being of the whole society.”  Despite this logic, I am more skeptical of beta corporate governance efforts because firm governance, like fund governance, is so context-specific.  Certainly, there are governance structures that are, on the one hand, likely to be highly correlated with high agency costs, and, on the other hand, there are structures which generally tend to reduce these costs.  These correlations seem to me to present an opportunity to evaluate a particular firm’s governance, however, and do not  justify market-wide governance prescriptions (although that is indeed what has been happening in recent years in areas such as board elections, particularly since ISS has gained influence as the mouthpiece for many institutional investors).  In other words, to the extent that CalPERS identifies under-performance and what it believes to be poor governance, alpha governance efforts would seem in order; exceptions to one-size-fits-all beta governance efforts would include rare cases such as divestment required by federal regulation.

To connect this discussion back to last week’s discussion of Temasek’s efforts, I believe that the regulation of foreign investment, at least in the US, tends to favor beta governance activism and not alpha governance activism.  For example, if NBIM decides to engage its US portfolio companies on executive compensation issues according to a standard set of parameters (e.g., NBIM will not vote in favor of comp plans with golden parachute provisions), this is less likely to trouble regulators than direct efforts to engage a particular company on a given issue.  Because of the way in which alpha governance activism is often conducted–private engagement with company managers–alpha activism may appear to a regulator as coming closer to the line of control or influence that may trigger review of the investment than would a broad beta signal that a fund will not support a particular kind of governance structure across its portfolio companies.

Temasek and the "Shareholder Spring"

Mark Kleinman reports that “Temasek Holdings, the Singaporean sovereign wealth fund, withheld its support from the re-election of six executive directors of Standard Chartered at its annual meeting last week.”  This comes as a surprise to many because Temasek had voted its 18% ownership in favor of the company’s slate in each of the prior 6 years.

Without commenting on the specifics of the vote (and as someone who is convinced that in many cases the motives of some shareholder activists are not in line with the best long-term interests of the portfolio company), the general idea that a SWF should actively vote its shares should not trouble regulators or other shareholders.  So long as SWFs disclose their voting, shareholder voting is one of the less problematic forms of shareholder activism because it is 1) visible and 2) typically constrained as to subject matter (since shareholders typically have only a small range of matters, such as election of directors, approval of auditors, and extraordinary corporate actions such as acquisitions, that are put to a shareholder vote).  I note that the Santiago principles recommends disclosure of proxy voting (and some SWFs do in fact disclose their voting policies and actual votes):

GAPP 21. Principle
SWFs view shareholder ownership rights as a fundamental element of their equity investments’ value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.

Of more concern are hidden forms of activism, such as direct pressure on management.  Even in these instances, however, a clear policy and disclosure of engagement should alleviate such concerns as well.  Although I am not always in agreement with the corporate governance philosophy of Calpers, the fund does provide a good example of how engagement should be conducted and disclosed (see, for example, their efforts with Apple).

While SWFs were right, I think, to remain relatively passive while political concerns were high in 2007-2009.  But as SWFs show themselves to be predictable, responsible investors, why should they not have a seat at the table?  Indeed, taking their place is an important aspect of their responsibilities as fiduciaries and shows their maturation as investors.

State Capitalism and the Foreign Corrupt Practices Act

The application of the Foreign Corrupt Practices Act to sovereign wealth funds and state-owned and/or controlled pension funds—the managers and employees of which would almost certainly be considered “foreign officials” by the DOJ and SEC—raises a host of issues that are only just beginning to be addressed in the growing literature on the FCPA.  I recently wrote a short article (available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2053456) as part of the Ohio State Law Journal’s symposium on the Foreign Corrupt Practices Act that attempts to sketch out some of these issues. 

 First, it is unclear whether the FCPA can or should be read to cover state-owned funds.  There are several practical reasons for arguing that it should not, among them a recognition that most of these enterprises and funds operate as quasi-independent entities that should not be viewed as direct agents of their respective governments.  These funds also typically (but admittedly not always or exclusively) serve economic and financial purposes, rather than a political or governmental purpose.

 Second, even if foreign enterprises and funds can be viewed as foreign instrumentalities, it is not clear that the FCPA provides the best remedy for the type of harm that occurs when a state-controlled fund employee is bribed. In non-FCPA contexts, the SEC has characterized the acceptance of bribes by fund managers as a breach of fiduciary duty to the fund investors.  Cast in these terms, the harm was an agency cost, and the SEC assists the fund investors by applying their enforcement resources to the cover some of the investors’ costs of monitoring the fund managers.  If the fund investors are the beneficiaries of this shifting of agency costs from private investors to public enforcers, who are the beneficiaries of a similar shift when foreign officials are bribed? 

 A third concern, related to the foregoing, is the apparent agency and judicial drift away from the original purpose of the FCPA as a tool to prevent corruption that affects foreign policy.  If this original purpose is to have any meaning in the context of state-controlled enterprises and funds, there must be a link between the foreign government, the instrumentality of the government, and the foreign officials who work for the instrumentality.  Each of these entities must be connected like three links of a chain—the foreign government linked to the instrumentality, and the instrumentality linked to the foreign official.  In this way, the acts of the foreign government have an effect on the foreign official, and the acts of the foreign official have an effect on the government.  Only if there exists this linkage between the foreign official and the foreign government—in the case of state-controlled enterprises and state-controlled funds, through their respective links to an instrumentality—should we expect to find the kind of foreign policy effect that the FCPA was designed to police.  Current SEC and DOJ interpretations, as well as the scant jurisprudence that has tested these interpretations, tends to look only at the connection between the foreign government and the instrumentality.  The legislative history of the FCPA, however, suggests that because foreign policy concerns are central to the FCPA, the link between the instrumentality and the foreign official must also be tested. To more directly rephrase the question of who is benefitted when the U.S. government pays for foreign fund agency costs, why are U.S. taxpayers paying for enforcement that serves to reduce agency costs for foreign governments, their citizens, and in some cases, the stockholders of partially state-controlled enterprises, but has no effect on U.S. foreign policy considerations?    

 

This article attempts to get at the core issue of the proper scope of the FCPA by considering who is an “instrumentality” and “foreign official” under the statute.  Additional clarity could be brought to this question by looking first at the link between the foreign government and alleged instrumentality.  Other areas of the law, including foreign investment law, have developed a substantial base of knowledge on the issues of foreign government control of state-affiliated enterprises and funds that could help inform FCPA jurisprudence.  As noted above, however, the more significant problem concerns the unidirectionality of current tests for “instrumentality” and “foreign official” status.  The tests used by the few courts addressing the issue have tended to look only at the issue of governmental control, but have ignored the link between the foreign official and the instrumentality—in other words, does the foreign official exercise control over the instrumentality so that there is a meaningful connection between the foreign government and the foreign official?  This analysis is key because if one takes the legislative history of the FCPA seriously, an FCPA prosecution is predicated on the ability of the foreign official to affect foreign policy.