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Canadian funds to establish Independent Review Committee by November

Date: Friday, August 25, 2006
Author: David Valentine & Michael Sharp, Blakes Securities Law

The Canadian Securities Administrators (CSA) have released National Instrument 81–107 Independent Review Committee for Investment Funds (the Instrument) in final form, which imposes a requirement on publicly-offered investment funds to establish an independent review committee (IRC) that is intended to improve the fund governance regime in Canada.

In 2002, the CSA released a concept proposal setting out their views as to the appropriate regulatory framework for mutual funds and their managers which included, among other recommendations, a call for improved mutual fund governance. In January 2004, the first version of the Instrument was published which was designed to deal with fund governance issues. In response to industry comments, the Instrument was substantially revised and republished in May 2005. The final version of the Instrument, published July 2006, does not differ materially from the May 2005 version.

Who the Instrument Applies to
The Instrument applies to any mutual fund or non-redeemable investment fund that is a reporting issuer in any Canadian jurisdiction. Funds become reporting issuers by filing a prospectus in a province or territory, or by having their securities listed on a Canadian stock exchange.

Principal Provisions of the Instrument

Establishment of the Committee. Each investment fund is required to establish an Independent Review Committee (IRC) which must have at least three members, all of whom must be “independent” of the manager. Under the Instrument, a member of an IRC is considered independent if “the member has no material relationship with the manager, the investment fund, or an entity related to the manager”; a “material relationship” is a relationship “which could reasonably be perceived to interfere with the member’s judgment regarding a conflict of interest matter”. The CSA in their commentary indicate that a “material relationship” could arise from a wide variety of relationships, both past and present, and provide some examples of both independent and non-independent relationships.

The Instrument provides the IRC with a number of powers designed to preserve its independence by insulating the committee from the influence of the manager. The initial IRC is established by the manager, but once established it fills its own vacancies, being required only to “consider” the recommendations of the manager in this regard. In addition, the manager may set the initial compensation and expenses of the IRC, but thereafter the IRC sets its own compensation and expenses, which must be “reasonable”. Such costs and expenses are paid out of the investment fund. There is no ability of the manager to remove members of the IRC, but the manager may call a meeting of securityholders for the purpose of removing a member of the IRC.

Liability of Committee Members. A major industry concern during the development of the Instrument has been potential liability of committee members, and the concern that fear of liability would have a dampening effect on the willingness of qualified individuals to serve on committees. Indeed, the Instrument charges the IRC with the same standard of care in conducting its activities as the investment fund manager. The CSA have attempted to address these concerns by strictly limiting the responsibilities of the IRC to a consideration of the conflict of interest matters referred to it by the manager for review; the Instrument provides that the IRC has no power, authority or responsibility for the operation of the investment fund or the manager beyond conflicts of interest. The Instrument permits IRC members to receive indemnification from the investment fund and to have insurance purchased for them by the investment fund, on terms comparable to those applicable to directors of corporations. The CSA state that they intend that IRC members be accountable for their actions, and that they believe that the “intention of indemnification is to encourage responsible behaviour yet still permit enough leeway to attract strong candidates”.

Conflict of Interest Review. Under the Instrument, the manager of an investment fund is required, when a conflict of interest matter arises, and before taking any action on the matter, to determine what action it proposes to take on the matter and refer the matter, along with its proposed action, to the IRC for its review and decision.

For certain matters, the manager cannot proceed with a proposed action unless it receives approval from the IRC. Those matters consist of matters prohibited by securities legislation, such as inter-fund trades, certain transactions involving securities of related parties or investment in securities underwritten by an entity related to the manager. For all other matters, the manager may proceed with its proposed actions so long as it “considers the recommendation” of the IRC.

This approach implements the long-promised review by the CSA and reform of the highly technical and, at times, unsatisfactory conflict of interest provisions in securities legislation. As the result of this Instrument, inter-fund trading, and the ability of investment funds to purchase securities underwritten by entities related to the manager will be permitted with IRC approval and other conditions prescribed by the Instrument. In addition, it will no longer be necessary for fund companies to obtain specific exemptive relief permitting them to hold securities of entities related to the manager.

What is a Conflict of Interest? The Instrument defines a “conflict of interest matter” to include both matters that are caught by the conflict of interest rules of securities legislation as described above, and also any “situation where a reasonable person would consider a manager, or an entity related to the manager, to have an interest that may conflict with the manager’s ability to act in good faith and in the best interests of the investment fund”. Given the potential scope of this definition, the key issue for the manager to resolve in beginning to work with an IRC will be determining what matters are “conflicts of interest” required to be considered by the IRC, as the Instrument requires that all conflict of interest matters must go to the IRC.

It is expected that the development of industry practice will inevitably play a role in providing guidance to managers in this regard. The CSA’s commentary suggests that industry participants attach some weight to the “reasonableness” test in the definition.

Another initial question to be faced by fund managers will be determining which ongoing practices and procedures of an investment fund need to be reviewed by the IRC. For instance, does the manager need to take an inventory of all practices in which it is now engaging and get the recommendation of the IRC; for instance, an existing investment fund will have determined how expenses are allocated between the fund and the manager. Will it be necessary to review that allocation?

Finally, the CSA noted in the notice accompanying the Instrument that they accept that changes in the “commercial bargain” between the investor and the manager are a matter for the securityholders to approve, not the IRC. This principle is not formally enshrined in the Instrument, and it will be interesting to see how it is applied in restricting the ambit of matters put to the IRC going forward.

Legal Compliance Matters. The implementation and operation of an IRC will entail the dedication of significant resources by an investment fund organization, particularly in the early stages, to ensure compliance with the documentary and other requirements of the Instrument. The Instrument prescribes a substantial number of formal mechanisms through which the manager and the IRC act and interact with each other, requiring the creation of written charters, policies and procedures, and written notices, recommendations and reports, both in respect of specific decisions and on an annual basis. These include an annual review by the IRC of the manager’s policies and procedures regarding conflict of interest matters, and the provision of an annual report to fund securityholders.

The Instrument comes into force on November 1, 2006, but there is a one year transition period. Managers must appoint the first members of the IRC for a fund by May 1, 2007, and the provisions of the Instrument then apply to the fund and the manager on November 1, 2007. A fund manager does have the option of electing to have the Instrument apply to a fund sooner than November 1, 2007, by giving notice to the fund’s principal regulator.

Various other instruments, including National Instruments 81–101 Mutual Fund Prospectus Disclosure, 81–102 Mutual Funds and 81–106 Investment Fund Continuous Disclosure, are being amended as a consequence of the introduction of the Instrument. In particular, the prospectuses of investment funds will be required to describe various aspects of the Fund’s IRC, including its mandate, composition and compensation.

The full text of the Instrument may be read on the Ontario Securities Commission Web site at www.osc.gov.on.ca or on Blakes Web site at www.blakes.com in our “Publications” section.