The Legal and Regulatory Framework for Pension Fund Investments – Rules versus Principles – Critical Issues and Challeng

1. The Legal and Regulatory Framework for Pension Fund Investments – Rules versus Principles – Critical Issues and Challenges Professor Poonam Puri Osgoode Hall Law School York University Wednesday June 4th 2008

2. Overview • Compare a rules based system with a principles based system for pension fund investments. • Identify opportunities and challenges in moving towards a more principles based system for pension fund investments. • Identify transition steps and possible approaches in moving towards a more principles based system.

3. Introduction • 2005 OECD: Guiding Principles for Regulatory Quality. • How do you evaluate the effectiveness and efficiency of pension investment regulation? • Are there clear objectives? • Is there a clear framework for implementation? • The regulatory framework should: • serve clearly identified policy goals; • have a sound legal and empirical basis; • produce benefits that justify costs; • minimize costs and market distortions; • promote innovation through market incentives; • be consistent with other economic goals; and • stimulate competition and efficiency.

4. Rules vs. Principles • The Rules Approach • Clear, specific, detailed rules that prescribe what a regulated market participant can and cannot do. • In the context of pension fund investments, rules are specific quantitative restrictions to limit the holdings of certain asset types/classes by the pension fund. • For example: • 10% maximum of the book value of assets in a single company’s securities. • 5% maximum in a single piece of real estate. • 30% of the shares that can vote to elect the board of directors.

5. Rules vs. Principles The Rules Approach Opportunities/Benefits: • Rules provide bright lines. • Rules allow for predictability. • Rules allow for certainty that laws have been complied with. • Rules allow for greater ease in monitoring compliance for pension fund (internally) and for regulator.

6. Rules vs. Principles The Rules Approach Challenges/Concerns: • One size fits all mentality. • Encourages a loophole mentality. • Bookvalue is used as opposed to market value. • Constrains the good judgment and decision-making authority of pension fund managers in their risk-return trade-off. • Increases the risks and costs of pension funds by limiting their opportunities for diversification. • Increases transaction costs by requiring legal maneuvering around the rules. (30% rule) • May force pension funds to become sources of financing government budgets or social investments.

7. Rules vs. Principles The Principles-Based Approach: • High level, general standards that focus on outcomes. • Interest in many regulatory spheres (accounting, securities) in moving towards more principles based regulation. • Many jurisdictions are moving towards more principles based regulation • FSA (Integrated regulator – 12 principles for business) • B.C. Securities Act/Commission (proposed) • Canadian Federal Government (Hockin Expert Panel) • Committee on Capital Markets Competitiveness/Paulson (US)

8. Rules vs. Principles • The Principles-Based Approach: • Why this interest? • Principles based regulation is consistent with deregulatory initiatives pursued by many governments around the world. • A recognition that there are multiple sources for the “regulation” – not just the regulator. • Companies are “agents rather than subjects of regulation.” • Regulators and regulated market participants are partners in a shared enterprise.

9. Rules vs. Principles The Principles-Based Approach in the Pension Fund Investment Context: • Prudent person standard requires that the fund administer invest using “the care, diligence and skill of a person of ordinary prudence..dealing with the property of another person.” • Responsibility falls squarely on pension fund senior management for implementation of risk/control systems to ensure that principles are being implemented. • The regulator is “more pragmatic, more willing to devolve responsibility to industry, and perhaps humbler about how well-informed and well-equipped it is relative to industry itself.”

10. Rules vs. Principles The Principles Approach Opportunities/Benefits • Not all funds are alike -- Allows maximum flexibility and responsibility to the fund manager. • Allows for enhanced stakeholder participation • Enables firms to experiment and seek out better, more innovative solutions. • Avoids the pitfalls of government direction and interference. • Relies on constant improvement. • Pension funds governed under jurisdictions which have the prudent person standards achieve better performance results than those governed under the rule based approach.

11. Rules vs. Principles The Principles Approach Risks/Challenges • Lack of certainty, lack of predictability. • Principle will be interpreted differently by different parties. • May encourage herding behavior by pension fund administrators. • Compliance monitoring and enforcement becomes more challenging for the regulator. • How would a breach of principles be the subject of an enforcement action taken by regulators or a civil suit by private parties? • All regulated participants (small and medium sized firms) may not be equally well placed to incorporate these principles into their internal systems.

12. The Small Funds Issue • Larger pension funds have the resources and capacity to have internal systems to make sure investments are prudent. What about smaller firms? • All regulated participants (small and medium sized firms) may not be equally well placed to incorporate the prudent person standard into their internal systems • What can the regulator do to assist in compliance for small and medium sized firms? • Should we have principles for larger firms and specific rules for small and medium sized firms? • Opportunities/challenges?

13. Implications and Challenges for Enforcement • When and how will the breach of a general principle be subject to regulatory enforcement? • Enforcement based on principles has been subject to tremendous criticism. For example, the term “gotcha enforcement” used for “public interest” power of securities regulators. • The FSA has indicated that it doesn’t expect to engage in much, if any, enforcement actions under the principles based regime. • Is this confidence inspiring?

14. Implications and Challenges for Enforcement • Can a principles based approach for pension fund investments be effectively monitored/enforced by the pension regulator? • in light of business judgments exercised when making investments? • in light of time horizons involved? • how so? • Regulatory review will likely inevitably have to be process based. • Similarities to corporate law context when judges have to review directors’ decisions --- see business judgment rule.

15. Conclusion • Where to from here? • Possible options and transition steps • Remove all specific rules from the guidelines? • Allow for discretionary relief/exemptions from the regulator upon application? • Principles for larger funds, rules for smaller funds? • Create capacity for smaller funds to implement a principles based system?

16. Contact Information • Poonam Puri • Associate Professor of Law, • Osgoode Hall Law School • ppuri@osgoode.yorku.ca • 416.417.2177 • 416.736.5542