Exercising Shareholders Rights Such as Voting Rights Entrusted to Discretionary Investment Companies

Transcription

1 Exercising Shareholders Rights Such as Voting Rights Entrusted to Discretionary Investment Companies April 2002 This translation is solely aimed at the convenience of those interested therein, and accordingly all questions that may arise with regard to the meaning of the words or expressions herein shall be dealt with in accordance with the original Japanese text. Japan Securities Investment Advisers Association (JSIAA) Study Group for Exercising Shareholders Rights Such as Voting Rights

2 April 26, 2002 Japan Securities Investment Advisers Association Study Group for Exercising Shareholders Rights Such as Voting Rights Exercising Shareholders Rights Such as Voting Rights Entrusted to Discretionary Investment Companies A report by Study Group for Exercising Shareholders Rights Such as Voting Rights Contents I Foreword 1 Background to the study 1 Circumstances 3 Relation to the fiduciary duty 5 Relation to the theories of the fiduciary duty and duty of prudence 5 The present law 10 Basic thinking 11 Basic policy 11 Screening criteria 13 Alteration of a client s instructions 15 Use of an advisory body 16 Incoherent exercise of the voting right 17 Possibility of obtaining insider information 18 The problem of who is to bear the cost 19 Shareholders rights other than the voting right 20 Underlying thinking 20 Provisions in the Investment Trust Law 20 The shareholder s rights to be exercised by a discretionary investment company 21

3 Creation of the environment 22 Institutional problems 22 The problem of exercising voting rights for foreign stocks 23 Concluding remarks 23 The cardinal duty of a discretionary investment company and the exercise of a voting right, etc. 23 Position as an investor, position as a shareholder Future direction 28

4 I. Foreword 1. Background to the study Regarding the instructions on exercising shareholders rights such as voting rights (hereinafter to be referred to as voting rights, etc. ), in 1990 the authorities stated that the power necessary for licensed investment advisers to make an investment for their clients, as defined in Article 2, Paragraph 4, of the Investment Advisory Law, includes the power to issue instructions to exercise voting rights (hereinafter to be referred to as the exercise of the voting right, etc. ). (Note) Licensed investment advisers are corporations that conduct business based on a discretionary investment contract under Article 24 of the Law for Regulating Securities Investment Advisory Business. Such companies will hereinafter be referred to as discretionary investment companies and the law will be referred to as the Investment Advisory Law. The authorities also said that discretionary investment companies can be entrusted with the power to issue such instructions if such power is necessary to make an investment. Since that time, discretionary investment companies have been issuing instructions to exercise the voting right, etc. under discretionary investment contracts. However, neither the definition of the instructions to exercise the voting right, etc. nor the way to appraise such instructions have been established, and clients have had little interest in them. For these reasons, clients and discretionary investment companies shared the view that the exercise of the voting right, etc. is only an act incidental to the business of asset management through investment in stocks. The authorities expressed those opinions in connection with the entry into the asset management business of employees pension funds and the Pension Fund Association (hereinafter to be referred to as employees pension funds, etc. ). Meanwhile, the main bank system s corporate governance function weakened with the collapse of the bubble economy. Against such a background, debate began over the need to establish corporate governance as it should be, which heeds the functions of the board of directors and the shareholders, and the voting rights of institutional investors including discretionary investment companies attracted attention. Thus, the environment for discretionary investment companies has greatly changed. 1

5 Next, let us examine the developments in Western countries (see Note). In the United States, the Department of Labor already in 1988 expressed a view in the Avon Letter that the duty of the exercise of the voting right is included in the fiduciary duty. (Note) In the United Kingdom, the voting right exercise rate (the percentage of votes exercised [either yeas or nays], votes withdrawn, and votes exercised by issuing a blank power of attorney to the total number of votes) was between 40% and 50% in It slightly rose later and stood at 51.4% in In the United States, on the other hand, the voting right exercise rate exceeds 80% as some pension funds of state government employees and trade unions pension funds began to exercise the right to make a proposal, but there are no cases where corporate pension funds have sponsored proposals in the capacity of shareholders. (Yumiko Miwa, Associate Professor at Meiji University). In the United Kingdom, The Review (the so-called Myners Report) advised in 2001 that all pension funds (fiduciaries) should spell out in their instruments for the delegation of asset management power the principle underlying the U.S. Department of Labor s notification of 1994 about the interpretation of the Employee Retirement Income Security Act (ERISA) of 1974 related to the exercise of the voting right, etc. and that those principles should be spelled out in Britain s law on a proper occasion. In the changed environment, in 1999 the Pension Fund Association made decisions relating to the exercise of the voting right, etc. in its basic management policy. In 2000, the Ministry of Health and Welfare s group to study the basic policy for pension fund management studied problems relating to the exercise of the voting right. Thus, the awareness of people concerned with the pension business about the voting right, etc., has surged in recent years. Some large-scale pension funds including pension fund management institutions have asked discretionary investment companies to handle voting rights, etc. in a more positive way than in the past, when they were handled as if bring of incidental importance. However, discretionary investment companies have had no perfectly clear idea about such things as the rights and duties relating to the exercise of the voting right, etc., the right s relation to buy/sell and investment decisions and the position of the exercise of the voting right in their asset management business. This is because, first, discretionary investment companies have mainly adhered to the so-called Wall Street Rule that says it suffices for them to sell shares except in some management styles, second, they considered the exercise of the voting right to be business that occurs incidentally and, third, the Investment Advisory 2

6 Law has no provision about the exercise of the voting right. Along with a rising awareness about corporate governance in Japan, expectations regarding the exercise of the voting right, etc. from highly skilled discretionary investment companies are surging, and making these issues clear has become an urgent task. We of the study group want to confirm and clarify these and study ways for their handling, providing a guideline, and performing our roles and responsibilities as a supporting base of the country s capital market. 2. Circumstances (1) Tripartite agreement about the exercise of the voting right, etc. The discretionary investment company is given the power to exercise the voting right in the case where the discretionary advisory contract contains a provision to that effect. The Investment Advisory Law has no provision about the exercise of the voting right by a discretionary investment company. When discretionary investment companies were planning to enter the business of managing the assets of employees pension funds, etc., in 1990, the parties concerned studied which would undertake the job of exercising the voting right, employees pension funds, etc., trust banks, or discretionary investment companies. On that occasion it was said that direct control of industry by the national government would result if employees pension funds were entrusted with the task of directly exercising the voting right because employees pension funds have agency departments, which have a public character. It was also said that the 5% rule of the Act Concerning Prohibition of Private Monopoly and Maintenance of Fair Trade (the so-called Antimonopoly Law) would be violated if trust banks were given a virtual power to exercise the voting right. After such possibilities were examined, it was agreed among the three parties that discretionary investment companies would exercise the voting right in the management of the assets of employees pension funds, etc. (2) A notification by MOF On March 16, 1990, a circular about the exercise of the voting right in the management of the assets of employees pension funds, etc., was issued by the director of the Investment Management Office, the Securities Companies Division, the Securities Bureau, of the 3

7 Ministry of Finance. (The circular was made into a notification (MOF Securities Bureau Notification No. 993 on July 20, 1992.) The circular made the following three policies: Instructions to exercise the voting right should be issued for the purpose of serving the client s general interest only, not for serving the interest of discretionary investment companies themselves or any third party. In the exercise of the voting right, discretionary investment companies should not receive any instructions from the client. In the exercise of the voting right, the process of making decisions about the substance of instructions concerning specific items on the agenda for shareholders meeting and the data that were the basis for the decisions made should be documented and preserved. (3) Self-regulatory rules of the Japan Investment Advisers Association In response to the above notification, the Japan Securities Investment Advisers Association (hereinafter to be referred to as the JSIAA ) on November 28, 1990, enacted self-regulatory rules titled Concerning the Proper Exercise of the Voting Right relating to Pension Fund Discretionary Investment Management Contracts to be observed in transactions with employees pension funds, etc. As the principles in making decisions about the exercise of the voting right by discretionary investment companies, the rules provide, among others: Instructions to exercise the voting right should be issued for the purpose of serving the client s general interest only, not for serving the interest of discretionary investment companies themselves or any third party. In the exercise of the voting right, discretionary investment companies should not receive any instructions from the client. The client s general interest means interest from the viewpoint of pure investment values, not interest aimed at the acquisition of the power to run a company. Judgments about general interest are up to investment decision makers. The above MOF notification, however, was revoked on June 8, There have been no formal expressions of views by the authorities ever since, and the matter is left to agreements among the parties concerned. Again, the opinion that the management of public funds by employees pension funds would lead to direct control of industry by the national government, which was the opinion 4

8 that was behind the notification, is undergoing a change with the surge of debate over corporate governance in recent years. II. Relation to the fiduciary duty 1. Relation to the theories of the fiduciary duty and duty of prudence Regarding the question of whether discretionary investment companies should exercise the voting right, etc., there are explicit provisions in the JSIAA s sample discretionary investment contract for pension funds and sample discretionary investment contract for retirement pension funds, but there are no provisions in discretionary investment contracts generally used by the pension funds of mutual aid associations. Thus, there have been no uniform rules about that, and as a result, the following points have been subjects of debate: To begin with, are discretionary investment companies allowed to practice the voting right, etc., under the Investment Advisory Law? Granted that they are allowed to practice such rights, what is the legal basis for that? Must discretionary investment companies undertake any obligation relating to the voting right even if there are no provisions concerning the exercise of the voting right in the discretionary investment contract? What is the scope of their duty relating to the voting right, etc., if they must undertake a duty relating to this right? (1) Grounds under the Investment Advisory Law Regarding and above, the first question is whether it is possible to consider that the definition of a discretionary investment contract (given in Article 2, Paragraph 4, of the Investment Advisory Law) includes the power to exercise the voting right. Article 2, Paragraph 4, of the Investment Advisory Law defines a discretionary investment contract as a contract under which an investment adviser is entrusted by a client with the task of making all or some of the investment judgments based on the analysis of a given security s value, etc., and is entrusted also with the power necessary to make investment for the client on the basis of such investment judgments. The discretionary investment contract has the following two factors: 5

9 (a) An investment adviser is entrusted by a client with the task of making all or some of the investment judgments based on the analysis of a security s value, etc. (b) At the same time with (a) above, the investment adviser is entrusted by the client also with the power necessary to make an investment for the same client on the basis of such investment judgments. (Note) The fiduciary duty is a concept that has grown under British and American laws. Originally, the fiduciary duty was a duty that presupposed mutual trust between the parties concerned. Historically, it became a duty that includes the awareness of relations of total dependence of one upon the other. In this report, the word is used mainly in the context of the second duty. In Japan, the fiduciary duty is often understood in the context of a clash of interest, and could not be excluded through agreement between the parties concerned. Whether the power to exercise the voting right, etc., is included in (b) above, not in (a), becomes a problem in connection with the voting right, etc. If we analyze (b) further, we come to the conclusion the power necessary to make an investment for the same client on the basis of such investment decisions is the core of a discretionary investment contract because the phrase for the same client expresses a matter of course. Let s logically interpret the power necessary to make an investment on the basis of an investment judgment. There may be an investment judgment that strongly urges the investment adviser to continue holding the shares it already holds in the company concerned because there is an outstanding business model at the company. Again, it may be said that the investment adviser is exercising the power necessary to make an investment on the basis of an investment judgment if the investment adviser casts a vote against the scheduled appointment of a new officer on the grounds that there are fears that the company s business model may fail to function well if the officer-elect becomes a member of the board. In other words, it may be said that the power to make an investment on the basis of an investment judgment includes not only the power to make an investment based on an investment judgment when the investment adviser has reached a certain positive investment judgment but also the power to exercise the voting right, etc., as a shareholder of a company for the purpose of removing serious harm to the investment value of the company (prevention of serious damage to the company s value) or the purpose of enhancing the apparent investment value of the company (promotion of the company s apparent value). Therefore, regarding the problems mentioned in and above, it may be said that 6

10 there are cases where the power necessary to make an investment for the client in Article 2, Paragraph 4, of the Investment Advisory Law includes the power to exercise the voting right, etc. (2) Fiduciary duty in the case where there are no provisions in the contract Next we want to examine whether discretionary investment companies must undertake any duty relating to the voting right, etc., even if there are no provisions concerning the exercise of the voting right, in the discretionary investment contract, which is the question asked in. Investment advisers, including discretionary investment companies, have a high-level duty of prudence (the observance of the prudent-man rule) toward their clients. This is explicitly mentioned in the report titled Concerning investment advisers duty of prudence submitted by the JSIAA s study group for investment advisers duty of prudence in September 2001 (hereinafter to be referred to as the prudence study group report ). In the interpretation of investment advisers duty of prudence, it is presupposed that (a) Investment advisers are asset management specialists. (b) Investment advisers are public entities that assume responsibilities for such affairs as the growth and fairness of the securities market and for the protection of investors. On the basis of such assumptions, it should be understood that discretionary investment companies have a high-level duty of prudence toward their clients in the spirit of the fiduciary duty. The relations between the high-level duty of prudence and Article 2, Paragraph 4, of the Investment Advisory Law can be understood as follows: The discretionary investment contract in its character is a trust contract under the Civil Law, and the parties to the contract can freely set its conditions within the bounds of the Investment Advisory Law, etc. Therefore, if the investment advisory contract has a provision about the power to order the exercise of the voting right, etc., the discretionary investment company must observe such provisions as a rule. In the case where the discretionary investment company has already made an investment in a company on the basis of an investment judgment, however, when it is necessary or useful to order the exercise of the voting right as a means to remove a serious 7

11 detriment to the investment value of the company or enhance the apparent investment value of the company, the discretionary investment company must perform the duty concerning the voting right, etc. (see III-1-(4) of this report) on the basis of a practical interpretation of the delegation of asset management or its gist as a specialist who must ensure the best interest of the final beneficiary (see Note). Therefore, regarding above, it should be understood that the duty relating to the voting right, etc., arises without any relationship to the provisions of the discretionary investment contract. (Note) It goes without saying that as mentioned in VI-1-(1), a discretionary investment company must give precedence to the so-called Wall Street Rule that requires selling of the stock concerned when there are fears that the value of the stock (the value of the company) will decline. (3) The scope of the duty relating to the voting right, etc. in. Next we will examine the scope of the duty relating to the voting right, etc., mentioned In the interpretation of the phrase In the case where the discretionary investment company has already made an investment in a company on the basis of an investment judgment, however, when it is necessary or useful to order the exercise of the voting right as a means to remove a serious detriment to the investment value of the company or enhance the apparent investment value of the company, the substance of the discretionary investment contract between the discretionary investment company and the client is one yardstick because of the nature of a trust contract. For example, if any client has requested the discretionary investment company to study, in making an investment judgment, whether it is possible to improve the performance of the company concerned by exercising the voting right, the scope of necessary or useful may be expanded. If, on the other hand, any client says that the discretionary investment company need not consider the exercise of the voting right, the scope of necessary or useful would become narrower. After all, the answer to the question in is: The scope of the duty relating to the voting right, etc., should be determined on the basis of the substance of the trust. To be specific, 8

12 (i) the case where the discretionary investment company already holds shares in a company on the basis of an investment judgment and the adviser exercises the voting right as a tool to remove a serious detriment to the investment value of the company or enhance the investment value of the company, and (ii) the case where the discretionary investment company exercises the voting right in a situation different from the one mentioned in (i) should be studied separately. In the situation mentioned in (i), there can be a case where the discretionary investment company has to undertake the duty relating to the voting right, etc., in the light of the fiduciary duty even if the discretionary investment contract has no provisions about the exercise of the voting right. In the situation mentioned in (ii), on the other hand, the discretionary investment company does not assume the duty relating to the voting right, etc., from the viewpoint of a high-level duty of prudence that accompanies the acceptance of the task of managing assets. Therefore, insofar as the discretionary investment contract has no provisions about the exercise of the voting right, the discretionary investment company is not bound to assume the duty relating to the voting right, etc. (4) Conclusion Summing up, in order to make the fulfillment of the fiduciary duty surer in the case of (i) where the exercise of the voting right is based on the fiduciary duty and in order to create the duty of exercising the voting right in the case of (ii), the discretionary investment contract must have a provision about the voting right, etc., and the basis for and the substance of the exercise of the voting right, etc., must be clarified. In other words, although the situation differs between (i) and (ii), the conclusion that the discretionary investment contract must have a provision about the exercise of the voting right, etc., is common to both. In addition, spelling out the client s will and wish in the contract is a task that a discretionary investment company must do in order to perform its responsibilities for the securities market. Because it is very difficult to determine under what circumstances it is necessary or useful to exercise the voting right, it is necessary to clarify in a discretionary investment contract or some other document the conditions that require the exercise of the voting right. 9

13 Again, it should be understood that the problem of violation of the duty of prudence or violation of the fiduciary duty would not arise insofar as the exercise of the voting right is based on criteria agreed upon between the parties to the contract. As mentioned in the report by the prudence study group, in the case where the client s knowledge or intelligence is insufficient or in the case where there are many final beneficiaries behind the client, as in the case of a mutual aid association, pension fund or insurance, the discretionary investment company should beware that it has to accept a high-level fiduciary duty based on such a condition. In other cases, on the other hand, it would suffice for the discretionary investment company to exercise only the voting right, etc., under the discretionary investment contract. 2. The present law Apart from the interpretation of Article 2, Paragraph 4, of the Investment Advisory Law mentioned before, the Investment Advisory Law has no provision that says the exercise of the voting right is a duty of a discretionary investment company. The Law concerning Investment Trust and Investment Companies (hereinafter to be referred to as the Investment Trust Law ), on the other hand, explicitly requires investment trust management companies to exercise several rights including the voting right (Article 22 of the law and Article 34 of its enforcement regulations). Why? Yoshinori Toda, chief of the Investment Trust Division, Securities Bureau, Ministry of Finance, explained the reason saying, [in] the comment on the Revised Securities Investment Trust Law and Ministerial Ordinance (a supplementary issue of Studies of Commercial Legislation (Bessatsu Shoji Homu Kenkyu) in 1968), it has become necessary to make it clear that investment trust management companies should assume the duty of exercising the voting right because there arose big debate over which was to exercise the voting right, investment trust management companies or fiduciaries. In the case of discretionary investment business, it was assumed that the problem of which the power to exercise the voting right belongs to was to be settled through agreement between clients and discretionary investment companies because the legal character of an investment advisory contract is a delegation contract under the Civil Law, which is a 10

14 negotiated contract, and as a matter of practical business, there is little difficulty in confirming the clients will or wish unlike the case with investment trust. III. Basic thinking 1. Basic policy (1) Purpose of exercising the voting right The discretionary investment company must exercise the voting right in the way it considers to be the best as an investment expert for the eventual purpose of maximizing the value of the company (the value of the stock) in which it holds a stake or to prevent damage to the value of the same. From such a viewpoint, the discretionary investment company must exercise the voting right by expressing approval or disapproval or abstaining from voting or issuing a blank power of attorney. It may not fail to exercise the voting right. It is allowed to issue a blank power of attorney when it thinks that it is the right choice to trust the board s management policy. It constitutes a violation of Article 30, Paragraph 2 (the provision requiring the observance of the fiduciary duty) if the judgment about the exercise of a voting right is distorted by keiretsu (corporate affiliation) or business transactions, and is prohibited. Even in the case where all the shares of the company are sold after the voting right s record date, the statement of profit disposition still directly affects the investment value of the company. Again, the discretionary investment company must exercise the voting right because it has a general responsibility toward the capital market as a fiduciary (see VI-1-(4)). (2) Provisions of a discretionary investment contract In the case where the discretionary investment company exercises the voting right In the case where the discretionary investment company manages such assets as securities including stocks for a client, which should exercise the voting right, the client or the discretionary investment company? In practical business, the answer to this question depends on the substance of the discretionary investment contract. In the case where the discretionary investment company must exercise the voting right, the discretionary investment contract has a provision to that effect, and in general, the 11

15 designated (money) trust deed or some other similar document between the client and a trust bank has a provision to the effect that the discretionary investment company, which is an agent, can issue instructions to the trust bank. The discretionary investment company becomes legally able to exercise the voting right only after a provision to that effect is spelled out in the designated (money) trust deed or some other similar document and copies of the notification of convoking a shareholders meeting, the instructions to exercise the voting right, etc., arrive from the trust bank. In the case where the client exercises the voting right In the case where the client is to exercise the voting right, the discretionary investment contract has no provision about the exercise of the voting right. In such a case, the designated (money) trust deed or some other similar document between the client and the trust bank has a provision to the effect that the client issues instructions to exercise the voting right to the trust bank. (3) Positive stance on exercising the voting right In order that a discretionary investment company may fully perform the fiduciary duty, it is a prerequisite condition that corporate governance is established and the capital market is being managed soundly. For that end, the voting right should be exercised effectively. The discretionary investment company, which is engaged in investment activities in the capital market as an expert and analyzes corporate management as a routine practice, is the best-suited party to undertake the role of making the market attain such conditions. Therefore, it is desirable for the discretionary investment company to actively urge its clients to delegate the power to exercise the voting right by drawing up guidelines for the exercise of the voting right or compiling the criteria for judgment, such as the screening criteria. In the case where the power to issue instructions is not stipulated in the contract, the discretionary investment company should ask the clients to delegate the power to issue instructions at such times as the time of renewing the contract. (4) Advising the clients to exercise the voting right intelligently Even in the case where the discretionary investment company has no power to issue instructions about voting, the discretionary investment company has a certain duty relating to 12

16 the exercise of a voting right from the viewpoint of the fiduciary duty, as stated in II-1-(2). For example, when the discretionary investment company can learn how a client is going to exercise the voting right and when the company has concluded that it is impossible to prevent serious damage to the value of the investment or enhance the evident value of the investment unless the client exercises the voting right differently and intelligently, the discretionary investment company should advise the client to exercise the voting right in the way it believes to be the best even if the discretionary investment contract has no provision requiring such counseling. (5) Effective exercise of the voting right Inasmuch as discretionary investment business is a business for profit, the discretionary investment company has to heed the relations between the cost for exercising the voting right and its effect. Therefore, the discretionary investment company is allowed to establish reasonable screening criteria, such as a profit standard and a standard about the number of directors, and exercise the voting right effectively. (6) Reporting the result of exercising the voting right As a rule, the discretionary investment contract should have a provision that requires the discretionary investment company to report the result of exercising the voting right. Even in the case where the discretionary investment contract has no such provision, from the viewpoint of the general reporting duty inherent in a fiduciary contract, the discretionary investment company must report important things, such as the name of the company concerned about which it has voted against any item on the agenda or abstained from voting on the grounds that its screening criteria have not been met. If reporting entails a cost, the discretionary investment company can request the payment of the cost by the clients. 2. Screening criteria (1) What attitudes toward screening Whether discretionary investment companies use screening as a tool or not and if they do, how they use it is a matter of each company s policy. For example, some companies 13

17 may select companies (stocks) by using such yardsticks as earnings (e.g., paying no dividends or operating in the red for XXX years) and decide to vote for or against each item on the agenda from the viewpoint of corporate governance. Some companies may use some other standard for screening other than the earnings level. As will be mentioned below, some standards may be used for other items, but the ideal form of corporate governance differs from company to company according to the scale of operation, the mode of operation, the industry to which the stock belongs, and there will be no universally absolute ideal form. In applying the screening criteria, the discretionary investment company should be reasonably flexible. (2) Examples of screening criteria In regard to the appointment of a director as an item on the agenda for the shareholders meeting, there is such a standard as the suitable number of directors or the rate of the size of top management to the number of employees. There is also a negative standard by which one rejects a person who has seriously damaged the shareholders interest or has taken part in a scandalous deal. The number of outside directors may also serve as a standard for screening. Whether the independence of the company will be maintained or not will also be used as a standard for voting for or against the appointment of an officer. Regarding the appointment of an auditor, the Commercial Law was revised in 2001, and as a result, large companies as defined in a special clause of the Commercial Law are required to appoint external auditors and the number of external auditors must be half or more of the total number of auditors. Thus, the scope of auditors has been enlarged, and the independence of auditors is now required more strongly than in the past. Under such circumstances, one may use the independence or not of the external auditors as one s standard for screening. Regarding the emoluments of officers and the retirement allowance for outgoing officers, one may consider, as a screening standard, whether there is a clear-cut standard for the calculation of such allowances. Again, one may consider whether the amount of such allowances (both the total amount and the amount per person) is proper or outrageous to common sense. 14

18 Regarding a proposal to introduce the incentive stock option system, such things may serve as screening criteria as the upper limit, the identities of the grantees, the strike price and the option s effective period. The conferment of a stock option may cause the transfer of a benefit from the shareholders to the grantee, so the company that plans to introduce the incentive stock option system should conduct sufficient studies. Regarding a proposal to alleviate the responsibility of a director, one may consider such things as the reason for this and whether the basis for calculating the monetary value of alleviation is clear. In view of the trend in expected revisions in the Commercial Law in the future, one may consider, as screening criteria, such things as the existence or not of a nomination committee, a remuneration committee and an audit committee. (3) Response to an antisocial act If any company has committed an antisocial act, it may be said that the corporate governance at the company has been deficient or there has been a problem in the company s managerial stance or philosophy. In such a case, one may have to exercise one s voting right in such a way as to bring into line the company s managerial stance or philosophy. Needless to say, such an act by a company is not the only inducement for the exercise of a voting right. There may be a case where even if an antisocial act has been committed, one should vote for a proposal on the agenda if the act has been redressed, efforts for improvement by the executives have been made and improvement or increase in the value of the company (stock) is expected. When any client demands that the discretionary investment company respond to a company that has committed an antisocial act, the discretionary investment company will have to ask the client to explain what an antisocial act means because the definition of an antisocial act is not clear enough. If the client fails to give a clear explanation, the discretionary investment company should itself define it and take the necessary action. 3. Alteration of a client s instructions (1) Active alteration by the discretionary investment company In the case where a client has indicated how to exercise the voting right, the 15

19 discretionary investment company, if it disagrees with the client s policy, should make a reasonable argument by showing its guidelines, screening criteria, etc., to the client in the fiduciary spirit. As said above, if the client s policy on how the exercise of the voting right is objectionable in the discretionary investment company s expert opinion, the discretionary investment company must confirm the rationale underlying the client s instructions as part of the fiduciary duty. By doing so, the discretionary investment company can avoid an incoherent exercise of a voting right, which will be mentioned later (III-5). (2) How to manage questionable instructions and policies There are cases where a client, after reserving the power to issue instructions about the exercise of a voting right, etc., delegates the power to exercise the voting right to each discretionary investment company under the discretionary investment contract. If, in such a case, the client s knowledge is insufficient and the concrete substance of how to exercise the voting right is questionable in the expert s eye, the discretionary investment company must state its views to the client. This is a part of its fiduciary duty. Again, in the case where the client itself has a fiduciary duty toward the final beneficiaries, as in the case of a pension fund, the discretionary investment company may be acting against the spirit of the fiduciary duty toward the final beneficiaries if it blindly obeys the client s concrete instructions when the instructions are questionable or unreasonable. In such a case, the discretionary investment company must advise the client to exercise the voting right beneficial to the final beneficiaries position. If, on the other hand, the client has sufficient knowledge about investment and there are no final beneficiaries behind the client, no problem will arise even if the discretionary investment company wholly entrusts the judgment about the exercise of the voting right to the client. 4. Use of an advisory body Use of an advisory body s service by a discretionary investment company in the exercise of a voting right is allowed if the discretionary investment company considers the advisory body s policy on the exercise of a voting right proper and if the discretionary investment company reserves the right to make a final judgment and undertakes that 16

20 responsibility. In the case of investment in foreign stocks in particular, there is a certain rationale in the use of an advisory body s service because of such factors as the difficulty of collecting information and the need to arrive at a decision quickly due to distance and time differences. The Investment Advisory Law does not assume a case where the discretionary investment company totally delegates the exercise of a voting right to an external body, such as an advisory body. In the case of foreign stocks, however, there may be a case where the need to delegate the exercise of the voting right is compelling. It is hoped that necessary measures to cope with such a situation will be taken. 5. Incoherent exercise of the voting right (1) Unified exercise of the voting right In order to fulfill its fiduciary duty as an expert, the discretionary investment company must lay down reasonable screening criteria (criteria for earnings, the number of directors, etc.), guidelines, etc., about the exercise of a voting right. Needless to say, no dissension can arise when the discretionary investment company exercises a voting right following the screening criteria and guidelines that it considers to be the best within the limits of its discretionary power for the exercise of a voting right. It is desirable to make utmost endeavors to prevent a lack of unity in the exercise of a voting right in order to ensure that the exercise of a voting right will produce its full effect. It is hoped that the discretionary investment company will go through the procedures necessary to exercise the voting right with coherence and unity. At a company engaged in investment trust, the exercise of a voting right without coherence or unity between the investment trust department and the discretionary investment department will not arise because such a company exercises the voting right following the screening criteria, guidelines, etc. (2) Possible dissension to arise in the exercise of a voting right It is possible that a difference in viewpoint on the exercise of a voting right exists among clients. In that case, the exercise of a voting right without unity may occur because a discretionary investment contract is a negotiated contract between two parties and the 17

21 discretionary investment company must follow the spirit of each contract. The lack of unity is unavoidable insofar as it reflects each client s reasonable wish. 6. Possibility of obtaining insider information (1) Presence of the problem As a rule, information to be collected for the exercise of a voting right is open information. The discretionary investment company analyzes such information and makes investment decisions by applying the guidelines and screening criteria to the results of the analysis. This is the ordinary decision-making process. There may be a case, however, where the substance of the agenda for a shareholders meeting or the explanation given in the notification of a shareholders meeting from the issuing company is questionable from the viewpoint of the prudent-man rule, which discretionary investment companies must observe as experts and further studies are considered necessary. In particular, in the case where serious damage to the issuing company s value arises if the items on the agenda are approved without modification, the collection of more detailed information is necessary. In the collection of detailed information, there may be a case where the important information about the company s operations obtained by interviewing the competent officer of the issuing company may prove to be insider information. The discretionary investment company must take steps to immediately suspend the transactions in the stock concerned, following its internal rules for the prevention of insider trading, if it has obtained insider information. As a result, the freedom of action in the management of assets will be impaired, and the portfolio s performance may deteriorate. In addition, the cost of clerical work will increase in the process of examining whether the obtained information is insider information or not. (2) Countermeasures In order to prevent the need to suspend transactions in a stock from arising even if the discretionary investment company has obtained insider information, the discretionary investment company should appoint a person in charge of exercising voting rights and erect a Chinese wall between that person and persons in charge of making investment decisions to cut off the flow of insider information to the investment decision-making department. This is 18

22 the minimum step to be taken. If any client expects a more active exercise of a right of shareholders than a mere exercise of the voting right, such as the exercise of the right to make proposals, or the collection of more information than the information accessible to the investing public, such a client had better be served by a special body that can meet such requirements, not by a discretionary investment company. 7. The problem of who is to bear the cost (1) The beneficiary should pay the cost principle The cost of exercising a voting right (remuneration and expense) as a rule should be borne by the client who is the beneficiary of the voting. In order to enable the discretionary investment company to properly manage the assets and exercise the voting right as an expert, the cost of its services should be borne in a proper manner. (2) The problem of the cost of managing pension fund assets At the time when a sample discretionary investment contract for employees pension funds was prepared, no in-depth debate was had over how much effort should be made to exercise a voting right. In those days, the average client thought it sufficed for discretionary investment companies to sell the shares following the Wall Street Rule if there was any problem in the company in which they had a stake. According to a recent debate, however, the discretionary investment company is required to exercise voting rights for clients in order to enhance the value of the stocks concerned, even though it entails a considerable clerical cost to exercise a voting right. If this is the client s real purpose of commissioning the management of assets to a discretionary investment company, the clients should bear a reasonable cost. In Japan, the remuneration to discretionary investment companies is lower than in Western countries. This is a conspicuous fact in the management of pension fund assets. If, in such a condition, the discretionary investment company is made to bear the cost of exercising the voting rights, the exercise of voting rights may become obligatory and perfunctory. Moreover, if in such a situation, the discretionary investment company tries to 19

23 exercise a voting right in the way that best serves the client s interest, the discretionary investment company will have to cut the cost of asset management and may become incapable of meeting client expectations on asset performance. Needless to say, the discretionary investment company should effectively exercise the voting right while heeding the cost-effect relations. At any rate, clients must bear the cost reasonably in order that the discretionary investment company may manage the client s assets and exercise the voting right properly. IV. Shareholders rights other than the voting right 1. Underlying thinking In order eventually to enhance the value of the company (the stock) or prevent anything deleterious, the discretionary investment company should order the exercise of shareholders rights (hereinafter to be referred to as the exercise of shareholders rights ) in a way it considers to be the best. For this purpose, it is desirable to explicitly mention in the discretionary investment contract that the discretionary investment company will exercise the voting right for the client. In the case where the client reserves the power to exercise the voting right, the discretionary investment company should ascertain the rationale in the client s policy if it considers, from the viewpoint of an expert, that the client s policy or way of exercising the voting right is reasonable. This is a part of the discretionary investment company s fiduciary duty. In particular, when the client has a fiduciary duty toward the final beneficiary, the discretionary investment company may be acting against the spirit of the fiduciary duty toward the final beneficiary if it blindly follows the client s concrete instructions when it considers the client s instructions objectionable or unreasonable. Therefore, the discretionary investment company must endeavor to persuade the client to exercise the voting right in the way that best serves the interest of the final beneficiary. 2. Provisions in the Investment Trust Law Unlike the Investment Trust Law, the Investment Advisory Law has no provision 20

24 about the exercise of shareholders rights. Therefore, it is impossible to deduce the discretionary investment company s duty to exercise shareholders rights from the letters of the Investment Advisory Law. However, discretionary investment business and investment trust business share the same character: both perform the management of assets through investment in securities. Therefore, provisions in the Investment Trust Law may serve as a guideline for discretionary investment companies in the way to exercise shareholders rights. The Investment Trust Law says that investment trust management companies have the duty of exercising shareholders following rights besides the voting right: <Article 22 of the Investment Trust Law> The right to demand conversion of a stock with a conversion right; Shareholders subscription right; The right to demand purchase of shares in the case where the client is opposed to the transfer of business; The right to demand the invalidation of a new share issue <Article 34 of the enforcement regulations of the Investment Trust Law> The right to demand suspension of the issue of new shares; The right to demand purchase of shares in the case of opposition to restricting the transfer of shares; The right to demand the invalidation of a capital reduction; The right to demand purchase of shares in the case of opposition to a merger; The right to demand the invalidation of a merger (Note) The right to underwrite the right to make an advance booking for new shares has been provided for in the revision of the Commercial Law. This right will have to be handled in the same way as shareholders subscription right. (Article , Paragraph 2, Subparagraph 12) 3. The shareholder s rights to be exercised by a discretionary investment company Most of the above rights of shareholders directly affect the value of the stock or defend the value of the company (the stock) in a greater degree than the voting right. Therefore, in view of the general theory underlying the fiduciary duty, it is thought that the discretionary investment company, as a rule, is required to exercise them as part of the 21