THE IMPACT OF PENSION REFORM ON CORPORATE GOVERNANCE PRACTICES AND REGULATIONS: THE CASE OF CHILE * Augusto Iglesias P. PrimAmérica Consultores September, 1999 Presented at the thirteenth Plenary Session of the Advisory Group on Privatisation, Organisation for Economic Co-operation and Development. Paris, France, September, *

I. Background information ¶Since the early eighties, pension funds have become important players in capital markets of many Latin American countries. This has been the consequences of radical reforms to their social security systems. ·Corporate governance practices depend, among other variables, on the size of capital markets, the characteristics of their regulation, and the ownership structure of firms. All these dimensions are affected by the development of institutional investors.

Pension Reform in Latin American (as of march 1999)

Fact N° 1: In L.A., pension fund investments are strictly regulated. All countries apply quantitative restrictions that include a list of authorized assets; diversification rules; conflicts of interest regulation; valuation rules; etc.... ¸To understand discussion on relationship between corporate governance and institutional investors in L.A. is necesary to know some basics facts regarding each one of this dimensions.

Investment rules for pension funds in Latin America

Fact N° 2: Allthough, in general, investment rules do allow investment in stocks in some countries the stock market is non-existent or is too small. So, only the pension funds of few countries invest in stocks....

Equity investments of pension funds in Latin America (as of march 1999)

aPension funds face important liquidity constraints. In many cases they can not sell their holdings of shares of one company without putting downward pressure on prices.... Fact N° 3: bAlso, there is no “index investment” because trading by pension funds would “move the index”. òBecause of these particular characteristics of the capital market, pensions funds have a “bias” in favor of an active role on corporate governance.

Fact N°4: Pension funds that are part of the social security system are not “company plans”. Individuals select the pension fund manager they want. Also, regulation limits the investments of the fund in assets issued by firms related to the pension fund managers....

Fact N°5: The particular design that has been selected for the new pension fund systems in L.A. (private management and individual freedom to select pension fund manager), means that there is low risk of political interference on investment decisions (and so, on corporate governance)....

Fact N°: 6 In general, ownership is concentrated (“family ownership”). So, as pension funds invest in stocks of one company they become “partners” of few big shareholders. Maybe because of this reason, the main purpose of regulation seems to be the control of conflicts of interest between minority and majority shareholders, and not the control of conflicts of interest between shareholders and the management of the firm....

II. Impact of pension reform on corporate governance ¶The development of institutional investors has influenced corporate governance (in Chile) in three differents ways: aPension funds and life insurance companies have an important presence in capital markets; bTo protect social security funds, new regulations have been introduced to capital markets with impact on corporate governance practices; cPension funds have appointed independent board numbers in many firms were they hold participation.

a. Pension funds, capital markets and corporate governance ÀPension funds plus reserves of life insurance companies amounted more than US$40 billion in 1998 (55% of GNP). Social security savings are 14% of total savings and 3.4% of GNP.

Chile: pension funds and reserves of life insurance companies (december of each year)

a. Pension fund, capital markets and corporate governance ÀPension funds plus reserves of life insurance companies amounted more than US$40 billion in 1998 (55% of GNP). Social security savings are 14% of total savings and 3.4% of GNP. ÁPension funds hold more than 50% of the outstanding debt of the government; 16% of total time deposits and bonds issued by commercial banks; 50% of mortgage bonds; 53% of long term corporate debt; and 10% of the stock traded in the market.

Chile: share of pension funds in financial markets 1/ 1/ Pension fund holdings of each asset class as a % of total assets in each class

... ÂUntil 1986, pension funds only invested in debt. So, their influence on corporate governance was only because their role as lenders of corporations who began to issue bonds as the market for long term debt developed: òPension funds and life insurance companies helped to the development of the market for long term debt; òCorporation who wanted to issue debt were forced to have an independent risk rating; òPension funds and life insurance companies did use their bargaining power to improve protections being offered to creditors. In short, the cost of long term debt did decrease; the cost of monitoring corporations was reduced; and the quality of the information that firms provide to the market did improve.

... ÃSince 1986, pension funds have been active investors in the stock market. As a proportion of the portfolio, investment in stocks did reach a maximum in 1994 (32,2%). Since then the proportion has decreased, mainly because international diversification of the portfolio.

Chile: Pension funds investment portfolio a/ Include Debt issued by Financial Institutions

... ÃSince 1986, pension funds have been active investors in the equity market. As a proportion of the portfolio, equity investment did reach a maximum in 1994 (32,2%). Since then the proportion has decreased, mainly because international diversification of the portfolio. ÄFirst, they did invest in state owned firms that were being privatized (most of them in the public utilities sector). Then they begin to invest in a broader range of firms.

Chile: Participation of pension funds in ownership of stocks * 1997

Chile: Participation of pension funds in ownership of open public corporations (december 1998) k Pension funds hold 10% of equity of open public corporations: l They participate in 99 firms (total number of firms traded in the market is 286). l In two firms participation is greater than 30% (but less than 35%). l In four firms, participation is between 20% and 30%. l In seven firms participation is between 15% and 20% l In twelve firms participation is between 10% and 20% l In seventy four firms, participation is less than 10%

... ÅThe incorporation of pension funds and - to some extent - life insurance companies to the stock market did help to increase its liquidity (at least for small investors, exit became an alternative in case of firms performing below expectations). ÆAlso, pension funds did begin to produce regular and independent opinions on the performance of firms. Later, they became the main clients for investment banks doing the same job. ÇBecause they are part of the mandatory social security system, pension funds are exposed to close public scrutiny. This also apply to firms were they invest. ÈFirms who want to go public and sell shares to pension funds, must meet certain minimum conditions (positive results in the last years; disclosure of relevant information; etc.).

b. Pension funds and capital market regulations ÀThe development of pension funds has had an effect on the design of capital market regulation. In turn, this regulation has had an impact on the role of institutional investors in corporate governance. ÁPension funds were created by law. They are part of a mandatory social security system. Therefore, there are some implicit - and explicit - state guarantees over results of the system. Capital market regulation was reformed with the purpose of reducing the cost of these guarantees. These changes in regulation have benefited not only pension funds, but also small investors and minority shareholders.

... ÂThe changes in capital market laws and regulations with direct influence on corporate governance practices are: òMandatory risk rating òControl of conflicts of interest ÃBecause of this, for shareholders and creditors, the conditions to participate in corporate governance have improved after pension reform.

c. Pension funds and monitoring of conflicts of interest ÀBecause of regulation, pension funds are forced to participate in shareholders meetings and to vote in each one of the decisions (including the election of board members), that are presented to the shareholders (this is not only in Chile but also in other L.A. countries).

Latin America: regulation on the vote of pension funds in shareholders meetings NR: Not regulated NA: Not available

c. Pension funds and monitoring of conflicts of interest ÀBecause of regulation, pension funds are forced to participate in shareholders meetings and to vote in each one of the decisions (including the election of board members), that are presented to the shareholders (this is not only in Chile but also in other L.A. countries). ÁPension funds face liquidity constraints (they can not sell their holdings in a short period of time without depressing prices). So, for them voice and vote are the most important tools for monitoring performance of firms. Then, because of regulations and market conditions, pension funds have been active in shareholders meetings and have elected independent board members.

Chile: Impact of pension funds on the election of board members Board members (Total) Board members elected with votes from at least one pension fund Chapter XII 8030 (37,5%) Other63141 ( 6,5%) Total71171 (10,0%) Class of firm

... ÂIndependent board members are playing an important role as monitors of potential conflicts of interest between mayority and minority shareholders (foreign institutional investors are playing a similar role). ÃBecause of the “demand” for independent board members by pension funds (an other institutional investors), a new “class” of professional board member is beginning to develop.

III. Some unsolved problems ¶In Latin America, there is some concern for the large relative size of pension funds in capital markets and the increasing concentration of this industry. Regulators fear that controllers of pension fund companies could control the firms in which the funds are invested, against the interest of the affiliates.

Latin America: concentration in pension fund industry

III. Some unsolved problems ¶In Latin America, there is some concern for the large relative size of pension funds in capital markets and the increasing concentartion of the industry. Regulators fear that controllers of pension fund companies could control the firms in which the funds are invested, against the interest of the affiliates. ·Regulators also understand that, effective participation of pension funds in corporate governance is important for the protection of minority shareholders. a) Fist problem

¸A mix of regulations is being used to “balance” both objectives:... òMaximum investment limits as a % of the outstanding shares of the company; òSpecial (reduced) limits, when there is some interest of pension fund managers in the firms where they want to invest; òMandatory and public voting of pension funds; òLimits to form coalitions with other pension funds; òStrong restrictions on voice.

¹In our opinion, the result of all these regulations is to weaken the potential influence of institutional investors on corporate governance (restrictions to voice and to form coalitions are the most questionable regulations)....

¶Some important institutions for corporate governance have not yet been developed: òAudit committes òCompensation committes b) Second problem

III. Final Remarks ¶Corporate governance practices evolve as a result of both law and tradition. In Latin America, pension reform did force regulators to create, in a very short period of time, a new legal framework for capital markets and the banking sector with the purpose of reducing investment risk and the cost of government guarantees in the social security system. These changes in regulation have had a strong influence on corporate governance.

·Regulations plus liquidity constraints have force pension funds to take an active role on corporate governance. However this situation could change as local capital markets develop and as pension funds begin to invest outside their domestic market....