Paul Calluzzo is assistant professor of finance at the Smith School of Business at Queen's University.
Last week, the Healthcare of Ontario Pension Plan (HOOPP) announced that it was providing an emergency $2-billion loan to Home Capital Group Inc., which has seen a run on its deposits and a steep decline in its stock price after the Ontario Securities Commission (OSC) accused the company of misleading disclosures. Interestingly, there are close ties between the two organizations. Home Capital chairman Kevin Smith was, until recently, a director of HOOPP. On the other side of the deal, on April 27, HOOPP president and chief executive Jim Keohane stepped down from his position as a director of Home Capital. While there is no evidence of impropriety, the fact that the two organizations are intertwined at the board level raises questions about the decision-making being made at the management level.
The loan provided by HOOPP fits a pattern observed in my research on board-connected investments. When companies such as Home Capital experience distress, other funds predictably flee – on average, they'll sell 15 per cent of their stake in the troubled firm. In contrast, board-connected funds such as HOOPP behave differently and tend to maintain their positions or even inject capital into the troubled firm. Although the fiduciary duty of directors requires them to act in the best interest of fund shareholders, when funds and publicly traded firms connect through a dual-employed director, fund interests can shift toward the director's private interests. This situation resembles asking an increasingly hungry cookie monster to guard a $70-billion cookie jar, and companies may try to use their boardroom connections to access management-friendly investors.
The problem with this investment is that HOOPP management is not responsible for the well-being of Home Capital shareholders. Instead, their responsibility is to the 321,000 Ontario health-care workers who depend on them for stable and reliable income in retirement. To achieve their mission, HOOPP must choose investments that appropriately balance risk exposure with expected reward. However, if it allows the self-interests of its board members to influence management's decisions, the retirement savings of plan participants may incur unnecessary risks.
In this case, the high-profile nature of the loan has shed light on what may have traditionally been done in the dark. HOOPP said as much when it revealed that "media speculation" had played a role in its decision to disclose the loan. However, most boards will not have this level of scrutiny applied to their business decisions, which means many shareholders could be exposed to unnecessary risk without their knowledge.
HOOPP's investment and board connections may also undermine confidence in management's decisions. Even if the investment turns out to be perfectly reasonable, the connections make it appear improper. This problem is compounded by the fact that Home Capital is under OSC investigation, as a related strand of my research shows that having directors from poorly governed firms can lead to poor governance at a fund. Under normal circumstances, defined benefit pension plans protect investors from the uncertainty of financial markets. However, the erosion of confidence caused by HOOPP's connection to Home Capital reintroduces uncertainty and can create disutility among the plan's participants.
To be clear, the presence of dual-employed directors need not be harmful to shareholders. These directors are likely to possess expertise that helps funds make better investment decisions. My research shows that funds with dual-employed directors earn higher returns than funds without them. It may be the case that funds use their information advantage to discern whether the distress at the connected firm is temporary and, if so, buy low. However, the data suggest that although trades in board-connected firms are on average profitable, a subset of connected trades in distressed firms produces negative returns, which suggests that director self-interest drives connected investments in distressed firms. That presents a problem: How is the shareholder to know whether these investments are based on keen insight or self-interest?
Disclosure laws provide some measure of protection, but the assessment of whether a conflict of interest is material is made by fellow directors, and the existence of the conflict will not always be obvious to shareholders. Greater transparency, brought about by stronger public disclosure rules, is the simplest way to give shareholders assurance that investments are being made with the shareholders' interest in mind and not to further a director's private interest.
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