Issue: March 2013 / May 2013
Editorials

RESPONSIBLE INVESTING

STRATE skewed

Pension funds’ shareholder activism, required by CRISA and regulations, is impeded by the operation of nominee accounts. Mehluli Mncube, managing director of Inkunzi Fiduciary Solutions*, discusses unintended consequences of dematerialization that need to be resolved.


Mncube . . . plumbing blockages

As “responsible” share ownership has come to the fore -- ushered by the Code for Responsible Investing in SA (CRISA), the revised Regulation 28 and FSB circular PF 130 that highlight the need for pension funds to actively manage their voting rights -- the spotlight must fall on custodian arrangements and ultimately on the nominee-account structure through which many pension investments are held. Most pension funds’ equity assets are held through central security depository (CSD), custodian, asset-manager or life-company nominee accounts.

Indirect holding system

A nominee account can be broadly defined as a type of account set up by a nominee (a market intermediary in most cases) for purposes such as administering securities or other assets on behalf of their beneficial owners. Simply put, it is a type of account in which the investor (e.g. a pension fund) holds its securities in the name of a different entity, i.e. the market intermediary or the CSD which acts as the nominee account operator and whose name appears on the register of the company.

In earlier days, physical possession of share certificates was the only accepted evidence of share ownership. Trading was through physical delivery of physical certificates. This proved costly, time consuming and inefficient. The nominee-account system developed to iron out these inefficiencies and, as volumes grew with the growth of capital markets, facilitate timely securities trading.

The indirect holding system was introduced. An investor neither received physical certificates nor appeared as the actual shareowner on the company’s register. Over 10 years ago, with the advent of STRATE (Share Transactions Totally Electronic), this indirect holding system was given force.

While the dematerialization produced efficiencies in securities trading and settlement, this indirect holding system poses several issues that could have adverse implications for such investors’ interests as shareholder rights. Use of nominee accounts by market intermediaries has a risk of depriving the ultimate beneficiary of its shareholder rights since the name of the nominee, not that of the pension fund, appears in the investee company’s’ register.

A pension fund, being an investor and shareholder of the company, enjoys various rights. These include economic benefits, communication, and actively participating in the company’s decision making through proxy voting or corporate engagement. As an investor, the fund has the right to vote on corporate matters, the right to call/attend shareholders’ meetings and the right to communicate with the board of the investee company. Challenges are posed by the nominee account.

Regulatory framework

Nominee companies are regulated by the Financial Services Board. When they want to register or hold any assets of long-term insurers, short-term insurers or pension funds, they need prior written approval of the Registrar of Long-term Insurance, the Registrar of Short-term Insurance or the Registrar of Pension Funds as the case may be. Nominee companies wanting to hold clients’ securities in the STRATE environment, by appearing in a sub-register maintained by a Central Securities Depository Participant (CSDP), must comply with the criteria determined by the Registrar.

Structure of nominee arrangements

Two types of nominee-account structures exist globally:

  1. Single-tiered structure: Where there is only a single layer of intermediaries (nominee-account operators) receiving orders and handling administrative affairs on behalf of individual account holders. Thus, a nominee account represents the securities holdings of individual accounts but cannot be expanded to create another layer of a nominee account and ultimate investors.

  2. Multiple-tiered structure: Where multiple layers of intermediaries (nominee-account operators) exist between the company and ultimate investors, a nominee account may represent the securities holdings of not only individual accounts (as in the single-tiered structure) but also another nominee account that again represents the securities holdings of its own ultimate investors.

Different jurisdictions have different structures. In SA the system is multi-tiered where multiple layers of intermediaries (e.g. asset managers, stockbrokers) exist between the investee company and the ultimate investors (pension funds). In the case of the nominee account serving a group of investors, their holdings are handled as if they represent one collective position. The nominee account operator, however, is required by law to keep separate records of each customer in its administration office.

Hurdles for activism

This indirect holding system presents challenges to the effective implementation of active share ownership as contemplated by CRISA, Reg 28 and PF 130.

  1. Shareholder communication. Since the nominee account operator’s name appears in the investee company’s register, the company is in the dark about the actual owners of its securities and may find it difficult to communicate directly with these ultimate owners. It is the mandate of the nominee-account operator to pass all information, like circulars about meetings, from the company to the beneficial owner. The existence of the nominee-account operator between the investee company and the shareholders may potentially cause a breakdown of the communication chain. Failure of the operator to pass on information timeously can potentially deprive the beneficiary owner of its shareholder rights. Voting at meetings or attendance is deadline driven.  However, developments in information technology and electronic communication have vastly lessened this concern.  Further, investee companies can be more proactive;

  2. Identification of beneficiary owners. Investee companies need to identify the underlying owners in case of meetings, major corporate events or providing feedback.  This is quite challenging in the multi-tier indirect holding system. For example, if the company needs to identify shareholders who have voted against management proposals, they have to go through the custodian and/or the asset manager before they can identify the actual investor. SA’s CSD model is advanced with rules requiring weekly disclosure of beneficial owners to the investee company. However, in the case of more than two layers (e.g. life company then asset manager), the legislation does not provide authority for enquiry beyond this;

  3. Minority shareholder rights: Minority shareholders may act collectively to maximize shareholder value when a major or controlling shareholder behaves contrary to their interests. For pension funds to respond collectively, they may need access to the identities of other minority shareholders who are often hidden behind asset managers’ nominee accounts;

  4. Reconciling votes: In the multi-tier account structure, the securities are treated as a collective position. When votes (proxies) are received from the various investors, they are sent collectively to the company as a bulk FOR, AGAINST or ABSTAIN position. Only through actual attendance at the meeting can each vote be submitted individually. This makes it difficult to reconcile who voted what from the issuer’s point of view. They have to enquire from the nominee-account operator as to the identity of the voter. While this is good for protecting the beneficiary, it is not good for engagement as the principles embedded in CRISA and PF 130 are about disclosure and visibility;

  5. Corporate engagement: For the beneficiary investor to engage directly with the investee company or attend shareholder meetings, a letter of representation has to be obtained in the name of the nominee operator. The letter of representation is in the name of the nominee operator, giving its proxy to the actual owners of the shares. This is ironic. It is a cumbersome process and also, from the perspective of the issuer, the beneficiary owners remain unidentified.

Blockages must be cleared

While strides are being made in setting the tone for responsible ownership and nudging pension funds to be active owners, the plumbing system is clogged with issues presented by the nominee-account system. Proxy voting is still overly manual and driven by the nominee operators. This presents contradictions in the auditing and reconciliation of votes cast. Company proposals/resolutions that by default (as guided by King III and international corporate governance) should fail or attract big dissenting votes, instead receive overwhelming support.

In practice, votes on such resolutions as the issue of shares for cash, independence of audit committees and shoddy remuneration policies seem almost invariably to pass with more shareholder votes than they should. In the current multi-tier indirect holding system, it is difficult to assess efforts of engaged and active investors.

The wave of active share ownership is rising. It is imperative that the plumbing blockages -- residue of old ways – be cleared to facilitate efficient and effective implementation of CRISA principles. Only then will all pension funds, as required by code and regulation, be able effectively to exercise the ownership rights attached to their investments.

* Inkunzi Fiduciary Solutions provides advisory services for institutional investors to manage key responsible-investing risks on voting and equity ownership. Amongst its clients are some top SA pension funds with approx R134bn in assets under advisement.