Ontario regulator offers outline of new fund governance rules

(December 4, 2003) The mutual fund industry faces a new governance regime that the Ontario Securities Commission (OSC) could unveil as early as this month, but there are still questions as to whether the new system will benefit investors.

Susan Silma, director of investment funds at the OSC, presented an outline of the new rules at the Canadian Institute’s 12th annual mutual fund symposium on Wednesday.

The draft rule — based on the March 2002 Concept Proposal 81-402 — has not yet been approved by all Canadian Securities Administrators (CSA) commissions, but Silma said it should be published by January at the latest.

“We know as regulators that it’s not easily regulated by prescriptive rules and we think a governance agency could do this much more effectively,” said Silma. “The rules will ensure that every manager will have a minimum level of fund governance. We think this is a good starting point and a platform for future reform, if appropriate.”

Under the rule, mutual funds will be required to adopt a governance regime which will focus on conflicts of interest. The Independent Review Committee (IRC) will review “all matters involving a conflict between the fund manager’s own interests and its fiduciary duty to its mutual funds.”

Such conflicts include related party transactions — replacing self-dealing prohibitions in the Securities Act and National Instrument 81-102 — and “any situation where a reasonable person would question whether the manager is in a conflict of interest.”

The IRC must also review current “fundamental changes” in Part 5 of NI 81-102, including some changes in the fund that currently require a unitholder vote.

“We are suggesting that some of the matters that are currently required to go to a unitholder vote not be required to go to a unitholder vote,” said Silma, using the example of a fund changing auditors.

Changes such as proposed fee increases and changes to the fund’s investment objectives would still require unitholder approval.

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The third area of conflict the IRC would review is inter-fund trading. The new governance rules would allow the purchase and sale of securities between funds with the same manager, subject to IRC review and specific conditions.

The IRC will also decide whether proposed actions will “lead to a fair and reasonable result for the mutual fund,” and make recommendations to the fund manager. Managers are not bound to follow the decision of the IRC, but the committee’s decision must be made public and the company must offer an explanation as to why the manager chose to ignore it.

The composition of the IRC will be subject to just a few key rules, leaving fund companies to decide upon the structure. The IRC must include at least three members and all members must be independent from the manager, the fund and entities related to the manager.

This last rule might prove the more difficult, since the inaugural board will be appointed by the manager. As these original members retire, the IRC itself will select replacements.

“Will we have enough qualified people in Canada willing to sit on these IRCs?” asked John Hall, partner at Borden Ladner Gervais. “They’d have to have at least a basic understanding of how the industry operates and some ability to read financial statements.”

He said it is possible the IRC will become a dumping ground for issues the fund manager won’t want to take responsibility for, but the OSC could expand the IRC’s mandate once it is in place.

“There’s the possibility that the manager could bring any issue to this board,” said Hall. “Will anything that comes to the board be something they should deal with and their reluctance or inability to deal with it be seen as potentially a breach of their standard of care? All of which ties into the liability question.”

He also warned that the committee could stifle risk-taking, since members could be averse to exposing themselves to liability for losses.

“Do we risk an environment where an IRC may decide to be unduly conservative because that’s the only way in which they won’t become liable?” he asked.

There is more room for conflict, though, as the IRC will set its own compensation, albeit after “taking into consideration the manager’s recommendation.” This compensation will be paid out of the funds’ assets, rather than the management expense ratio (MER), effectively burying it along with trading fees.

On top of that expense, the IRC will need liability insurance and its own counsel if a scandal does arise.

“Will the investing public really thank you for fund governance at the end of the day if, because of insurance, compensation and so on, you’ve added more to your MER?” asked Hall.

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Will the IRC raise the bar on fund governance? Or is the industry clean enough already? Will the added oversight help or hurt the average investor? Share your thoughts about this topic in the Talvest Town Hall on Advisor.ca.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(12/04/03)

Steven Lamb