King IV extends application to retirement funds and introduces sector supplements for easier application

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By David Geral, partner, Banking and Financial Services Regulatory, Bowmans South Africa

The King (IV) Report on Corporate Governance for SA, 2016 (King IV) refers to certain “paradigm shifts in the corporate world”, including a shift from short-term capital markets to long-term, sustainable capital markets.  The report also notes that the King Committee was requested by many entities outside the private sector to draft the King IV Report in such a way as to make it more easily applicable to all organisations:  public and private, large and small, for- profit and not-for-profit.  As a result, in order to make it easier for all organisations to use the King IV Report as a guide for good governance, King IV introduces “sector supplements” for the first time.  Part 6.4 of the report is entitled “Supplement For Retirement Funds”, and  it is applicable to all retirement funds, including pension funds, provident funds, preservation funds and retirement annuity funds, so that for the first time retirement fund governance is directly addressed by the King Committee.

The King IV report has also moved from an “apply or explain” to “apply and explain” model and has reduced the 75 principles in King III to 17 basic principles. In order for any institutional investor to substantiate a claim that it practices good governance, it must be able to demonstrate the implementation and practice of all 17 basic principles.  The Supplement translates those principles into the retirement funding context.

The Supplement makes the point that retirement funds make investment decisions and have rights as shareholders, and that the way in which their decisions are made and their rights are exercised, can reinforce or weaken the corporate governance of the companies in which those retirement funds invest.  King IV proposes responsible investing principles and practices as part and parcel of the good governance of retirement funds.  It specifically makes mention of the opportunity for retirement funds in South Africa to subscribe to the Code for Responsible Investing in South Africa (“CRISA”), a voluntary code applicable to institutional investors, in addition to their boards’ statutory fiduciary duties under the Pension Funds Act, and the guidance offered in circular PF130.

Of the 17 principles in King IV, all of which are all applicable to retirement funds, certain deserve specific mention.

Principle 2 states that the board should govern the ethics of the fund in a way that supports the establishment of an ethical culture.  Of particular relevance to retirement funds is the recognition that most retirement funds outsource their administration and investment management services, and the point is made that whenever services are outsourced, the board should satisfy itself that the fund’s service providers manage their own ethics effectively through codes of conduct, ethics policies and supporting processes.

Principle 3 enjoins the board to ensure that the fund is, and is seen to be, a responsible corporate citizen.  The Supplement notes that this principle conveys essentially the same message as Regulation 28 under the Pension Funds Act, namely that prudent investing “should give appropriate consideration to any factor which may materially affect the sustainable long-term performance of the fund’s assets, including factors of an environmental, social and governance (ESG) character”. A retirement fund gives substance to its duty to be a responsible corporate citizen by ensuring that its investment analyses and practices, must take account of ESG considerations whether executed by the fund itself or by an asset manager or other service provider on its behalf.  In short, the fund should accept ownership responsibility for its investment arrangements and investment activities.  These iterations of Principle 3 are strikingly similar to the content of the first two principles in both CRISA and the United Nations Principles for Responsible Investments (UNPRI).

In terms of Principle 4 the board should appreciate that the fund’s core purpose, its risks and opportunities, strategy, business model, performance and sustainable development are all inseparable elements of the value creation process.  In this regard the Supplement notes that the performance of a retirement fund consists of delivering targeted investment returns in terms of its investment strategy without irresponsible risk–taking, and managing expenses to maximise value for money.  It notes that for a retirement fund it is especially critical that a long-term view is taken of the fund’s performance in the interests of its members because, unlike a commercial enterprise, the purpose of a retirement fund is more narrowly defined to provide benefits to its members, beneficiaries and dependants in accordance with its rules.

Principle 5, requires the board to ensure that reports issued by the fund enable stakeholders to make informed assessments of the fund’s performance and its short, medium and long-term prospects.  Once again the message resonates with the content of principle 5 of both UNPRI and CRISA, and King IV recommends the latter as an appropriate mechanism for disclosure and accountability in respect of investment decisions and activities.

Principle 7 states that the board should comprise the appropriate balance of knowledge, skills, experience, diversity and independence for it to discharge its governance role and responsibilities objectively and effectively.  The Supplement notes that even though the election and appointment mechanisms of members of retirement fund boards are prescribed in legislation, the boards of retirement funds should still, of their own accord, strive towards the aspiration expressed in principle 7.  It suggests that one of the ways to do that is to use external expertise to assist the board with its oversight duties in the event that objective input on specific matters outside its knowledge, skills and experience is required.

The Supplement notes that employers or sponsors are in a position to use their powers of appointment to ensure that the board has members with the necessary expertise and experience, and should do so.  Board members appointed by the employer should not, according to the Supplement, be involved in the employer’s decisions as regards to the fund and an employer should not use its power of appointment of board members to ensure a measure of control over funds.

Further, a process of engagement with the employees who elect retirement fund board members should be initiated (by the fund’s board) in order to convey the nature of board members’ duties and the competencies required, so that informed nominations and elections can take place.  The Supplement notes that as in any organisation, professional development and learning are of critical importance and it recommends that ongoing development programmes should include responsible investment and ESG matters. Despite the inherent sense and fairness in all these recommendations, the substance of Principle 7 is at odds with typical practice in many South African occupational and sectoral funds.

Principle 9 says that the board should ensure that the evaluation of its performance and that of its committees, its chair and its individual members, support continued improvement in performance and effectiveness.

Principle 10 again addresses delegations and outsourcing.  It challenges the board to ensure that the appointment of, and delegation to, management contribute to role clarity and the effective exercise of the authority and responsibilities.  The Supplement notes correctly that delegation of responsibilities to a third party does not absolve the board from accountability, and recognises oversight of service providers as an integral part of the board’s governance function.

The practices recommended under Principle 10 provide helpful guidance on oversight of management and should be applied by the fund’s board with appropriate adaptation in relation to fund administrators and other service providers.  Some of the basic elements of appropriate delegation would include that a clear mandate be in place between the fund and the service provider, which should provide for performance measures and targets in respect of all delegated functions including the application of responsible investing principles and practices.  The Supplement provides that the board must be especially proactive in overseeing how service providers manage their conflicts of interests, particularly if a fund participates in pooled investments managed by the same investment manager.

Under Principle 10 the Supplement also notes that the role of a fund’s principal officer is significantly similar to that of a company secretary and recommends that boards of retirement funds must appoint a suitably experienced professional to provide those services.

Principle 17 states that the board should ensure that responsible investment is practiced by the fund to promote the good governance and the creation of value by the companies and funds in which the fund invests.  Again the Supplement invokes the principles of responsible investing advocated in the CRISA code as necessary for good governance.  Although UNPRI is not mentioned it must be regarded as relevant given its in-principle similarities to CRISA.

Although King IV is not binding on South African retirement funds it is undeniably “applicable” in the sense that it can be readily applied in a practical manner to the management, oversight and governance of retirement funds, especially since its content has been explicitly ‘unpacked’ in the Supplement.  It does not replace Circular PF130, which retains its relevance.  It does, however, create a useful aspirational standard against which to measure board performance, especially by boards which are keen to measure and evaluate, and thereby improve, their own performance.

For the time being King IV does not set legal standards against which a court or other tribunal could readily measure the lawfulness or wrongfulness of board members’ conduct, but it will undoubtedly have an influence in giving some clearer expression to what amounts to reasonable conduct by a reasonable trustee.

The fact that the Supplement refers almost exclusively to CRISA – which is a private, voluntary initiative among other similar initiatives – is a little surprising and limiting but that in no way detracts from the undeniable value of CRISA as a set of relevant, best practice guiding principles.  However retirement funds should also consider the material available from similar organisations, including UNPRI, the Sustainable Returns Project, the European Sustainable Investment Forum and its affiliate, the South African Sustainable Investment Forum, among others.