The United States is the most developed financial services market, holding close to half of the world’s $42 trillion invested in mutual funds. Assets are invested in domestic companies as well as in companies outside of the United States. The United States’ views on corporate governance permeate global markets. U.S. asset managers must have an understanding of the governance framework that exists in the foreign markets in which they invest.
Magna Carta of Shareholder Rights
In response to intense discussions among fund sponsors triggered in part by the Department of Labor, in 1988 Gabelli & Company, Inc. (GAMCO) published a “Magna Carta of Shareholders Rights.” This document provided the framework for how the Firm would address certain corporate governance issues. The underlying principle remains in place today: “Gabelli is neither for nor against management; it is for shareholders.” The corporate governance practices Gabelli views favorably include cumulative voting, golden parachutes, one share: one vote, cash incentives, and pre-emptive rights. In general, Gabelli opposes greenmail, poison pills, super-majority voting, blank check preferreds, and super-dilutive stock options.
The Magna Carta serves to proactively put companies on notice as to how GAMCO votes on a particular issue. In cases where a company takes an action contrary to the Magna Carta, GAMCO will often refer a company to the Magna Carta of Shareholder Rights in a 13d filing. While the Magna Carta of Shareholder Rights was revolutionary in 1988, in 2003 the SEC formalized the requirement that investment advisers adopt written compliance programs, including how they vote on proxies. Investment companies are further required to annually disclose on Form N-PX how they voted on each proxy proposal during the previous year.
Pitfalls to Be Aware of When Investing Outside the United States
Class Action Lawsuits
In the United States there is a litigation culture unlike in any other developed country. In 2016, 73 percent of all completed corporate deal transactions attracted at least one lawsuit. While the number continues to decline as Delaware courts (the most popular domicile for U.S. corporations) have become less tolerant of frivolous merger-related lawsuits, the legal environment is vastly different from Europe’s. In the United States, a shareholder may file a legal complaint at virtually no expense and with no exposure. The defendant company is forced to expend resources to hire lawyers to defend against the lawsuit or to engage a firm to settle the claim, including paying the plaintiff’s attorney the equivalent of extortion. In merger-related lawsuits, settlements often include a minor revision to disclosure statements and a payment to the plaintiff’s lawyers.
In contrast to the United States, in Germany, Canada, and other foreign jurisdictions, the loser of a lawsuit is forced to pay the attorney’s fees and related expenses of the defendant. U.S. investors accustomed to joining U.S. class action cases must evaluate the risk that exists in joining a lawsuit in a foreign jurisdiction. In complex litigation outside the United States, class members have to have an understanding of the ramifications of participating in the lawsuit.
For example, our Firm was involved in a particular litigation where the foreign plaintiff’s counsel lobbied strongly to participate in a class action lawsuit. However, since our Firm had already opted out of the class action on similar claims in the United States, we were unable to join the foreign lawsuit. Unbeknownst to us at the time, if we had joined the foreign lawsuit, it would have precluded the much larger recovery we were pursuing domestically. In addition, it would have exposed us to legal and other expenses, if the lawsuit were lost.
Popular outside the United States is a practice where companies reward long-term shareholders by paying a larger dividend, issuing additional voting rights, or giving the right to acquire additional shares at a discounted price. While we are “buy and hold” investors, incentivizing shareholders simply for their longevity is not good corporate governance. The United States has a de facto reward system built into the tax code, with lower taxes for investors realizing gains after holding their shares for twelve months.
Ownership Reporting Obligations
Institutional investors in the United States report ownership positions on Schedule 13 d/g when their ownership position reaches five percent. The investor has the obligation to update ownership changes of one percent following an initial report. One criticism of 13d reporting is that activist investors have frequently operated as “wolf packs,” where a series of funds collectively own over a five percent stake in a particular company but individually are below the reporting threshold to avoid disclosure. Currently, there is a bill before Congress, the Brokaw Act, which would serve to close the reporting loopholes used by activist investors. In addition to Schedule 13 d/g, corporate officers, directors, and insiders are required to report share purchases and sales to the SEC on Forms 3, 4, and 5. Institutional investors with investments over $100 million are required to disclose their holdings quarterly on Schedule 13f. All of these reports are aimed at providing transparency to insure all market participants have the full landscape of information.
While the United States has a fully developed reporting system, each foreign market has their own particular reporting requirement. For example, investors in the United Kingdom buying or selling shares of a company subject to a corporate transaction must monitor the UK Takeover Panel. The Takeover Panel regulates takeover bids and other merger transactions for companies that have registered offices in the United Kingdom. Investors are required to file a Disclosure Form with the Panel if they own one percent or their position changes by one percent for any company that appears on the list published by the Takeover Panel. Substantial shareholder reporting thresholds vary widely by jurisdiction, ranging from as low as two percent in Italy to as high as 33.3 percent in Belgium. Several jurisdictions outside the United States also require the report of short sales.
Larger investment management firms (which are most likely to acquire ownership stakes large enough to trigger reporting) are often best equipped to handle the regulatory requirements through the use of technology and portfolio surveillance. The portfolio management team is likely aware of the investment reporting levels, but it is unlikely to be a factor in their investment decision. However, smaller firms with limited infrastructure and personnel may inadvertently trip a reporting threshold and be unaware of the consequences of doing so. In my experience, the securities regulators in jurisdictions outside the United States are quite helpful, responsive, and sympathetic to outsiders who inadvertently trip a reporting requirement.
In one particular situation several years ago, there was a timing question regarding when a particular filing in the UK was required. In the United States most people’s first call is to outside counsel, who will research the answer, weigh the various rule interpretations, and then provide the predicted outcome. While I do not disagree this is a prudent course of action, I instead dialed the UK regulator directly, intending to proceed on a “no names” basis to determine the answer to my question. It quickly became apparent that not only was the regulator extremely sympathetic to my confusion, but he was genuinely interested in assisting to expedite the filing. I took a risk in disclosing the name of the firm. In return, the official explained to his supervisors the inadvertent nature of what turned out to be a late filing, and the only consequence was a reprimand to make sure the filing was timely the next time. I have had similar positive experiences interacting directly with the Canadian regulators and the Japanese regulators.
Specific Corporate Governance Codes
It has become commonplace in the United States for corporations to publish their own Code of Ethics. The Securities and Exchange Commission has prescribed rules for the asset management industry which require investment advisers to adopt a Code of Ethics, and to disclose particular aspects of its Code in their Form ADV. While most of the Rules are intuitive, our Code provides black and white guidance on topics like how long an individual must hold a particular security after purchasing it for their own account, or how much money they are permitted to contribute to a political candidate. The Code of Ethics also addresses what action should be taken if an individual becomes aware of improper conduct. The most effective means of educating teammates on Code of Ethics issues is training, in the form of a continuous dialogue and reminders including annual in-person training, periodic training videos, firm-wide e-mail reminders and firm-wide telephonic training calls. Most importantly, a tone of compliance should be set from the top. When significant breaches occur at other companies, we utilize the breach as an opportunity to discuss with teammates and learn from others’ mistakes.
Japan’s Stewardship Code is an example of a foreign jurisdiction moving rapidly to adopt progressive and transparent Code of Ethics reporting by institutional investors. The Stewardship Code is voluntarily adopted, including a set of principles by which adopting firms choose to abide. The Japanese Financial Services Agency maintains a registry of firms that have adopted the Stewardship Code. Our Japanese subsidiary has adopted the Stewardship Code and has been given an “A” rating from Nomura Research Institute (NRI).
Ultimately, we operate in a fishbowl. We operate on the assumption that every action we take will be scrutinized by regulators, our clients and prospective clients. We take our fiduciary obligation seriously. As businesses continue to evolve globally, it is of paramount importance to continue to understand the nuances that come with investing in each foreign market. While these nuances are sometimes subtle, a breach in a new jurisdiction may have dire consequences to your efforts to grow your business. It is therefore important to understand both your domestic market obligations as well paying particular attention to other jurisdictions when venturing outside your home market.
About the Author:
David M. Goldman is General Counsel of Gamco Asset Management, Inc., serving as the investment advisor’s chief legal officer, with responsibility for the full range of legal and regulatory matters affecting Gamco’s separate account and open-end and closed-end fund business. Mr. Goldman serves on the Boards of Gamco’s UK and Japanese affiliates. Prior to that, Mr. Goldman spent ten years at Deutsche Asset Management, Deutsche Bank’s U.S. asset management business in various roles including compliance, legal, and the Office of Board Relations.
Mr. Goldman graduated from Georgetown University Law Center (LLM, Concentration in Securities Regulation), University of Maryland School of Law (JD), and Indiana University (BS, Accounting). He holds a CPA license (inactive) and is a member of the Maryland bar and has spoken at numerous conferences.