Proposed mutual fund governance regime flawed, analyst says

(April 7, 2004) A proposal by the Canadian Securities Administrators (CSA) to introduce a new mutual fund governance regime is seriously flawed, says Morningstar Canada’s director of analysis.

“The proposal does not do enough to establish an effective independent oversight mechanism,” Mark Warywoda says in a column posted on Morningstar Canada’s Web site. “At the same time, it reduces existing investor protection.”

The CSA’s draft rule would require fund companies to set up independent review committees (IRCs) for each fund, with a mandate to review fund managers and potential conflicts of interest.

The umbrella group for Canada’s provincial and territorial securities regulators had originally called for funds to set up independent boards of directors, similar to the U.S. model, but backed off that approach in response to criticism from the mutual fund industry. Unlike boards, IRCs have no power to overrule fund managers.

Warywoda says he’s troubled by the fact that the proposed committees would have limited powers. “The IRCs would have no authority to issue binding recommendations,” he says. “Though the proposal ostensibly obligates the fund manager to refer all conflicts of interest to the IRC for review, the fund manager will not be required to adhere to the IRC’s recommendation.”

That means fund managers could in theory proceed with an action the committee has deemed to be a conflict of interest, Warywoda notes, as long as the manager discloses that fact in the fund’s prospectus.

“The proposal thus limits the IRC to whistle-blower status,” he says. “This amounts to relying on the hope that investment managers will always follow IRC recommendations for fear of otherwise risking their reputations.”

Although the CSA says it is attempting to strike a balance between improving investor protection and enhancing market efficiency, Warywoda maintains the scales are in fact tilted in favour of the interests of investment managers at the expense of investors.

Warywoda suggests that IRCs be given the mandate to oversee all potential conflicts, not just those presented by the fund manager. “Finally, they should be empowered not just to make recommendations, but to enforce their decisions.”

The proposed rule would also repeal a number of existing regulations aimed at eliminating conflicts of interest, Warywoda says, instead relying on the authority of the new IRCs.

“This approach is rather controversial, given the current environment of increased scrutiny of industry practices in Canada and the abuses uncovered in the U.S. mutual fund industry,” he says, conceding that the CSA’s move to a more flexible governance regime is consistent with the philosophy behind regulatory reforms adopted in other jurisdictions around the world.

The CSA’s proposed National Instrument 81-107 Independent Review Committee for Mutual Funds was published in January 2004. The comment period ends this week.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com