The Instrument and related amendments
The Instrument requires every investment fund that is a reporting issuer to have a fully independent body (the Independent Review Committee, or IRC) which is responsible for overseeing decisions that pose or have the potential to pose a conflict of interest. The Instrument also sets out a standard of care for investment fund managers with a view to ensuring that the interests of the investment fund are at the forefront when a fund manager is faced with a conflict of interest.
The Instrument applies to all public mutual funds, labour-sponsored or venture-capital funds, scholarship plans, and closed-end funds listed for trading on a stock exchange or quoted on an OTC market, regardless of size. It does not apply to pooled funds that sell securities to the public on a private-placement basis only, nor does it apply to funds that invest for the purpose of exercising control of, or being actively involved in, the management of issuers.
The Instrument will have far-reaching effects on the investment fund industry, with several consequential amendments also contemplated for various other instruments, including NI 81-101 - Mutual Fund Prospectus Disclosure, NI 81-102 - Mutual Funds, and NI 81-106 - Investment Fund Continuous Disclosure. Existing conflict of interest and self-dealing prohibitions in securities legislation will continue to apply, subject to exemptions in NI 81-107 and NI 81-102 allowing a manager to proceed with certain transactions that have received IRC approval under the Instrument.
Conflict of interest matters
The fund manager is expected to refer all matters in which a conflict of interest arises or is perceived to arise to the IRC in accordance with policies and procedures determined by the manager. This is consistent with the manager's overriding duty to act honestly and in good faith, and in the best interests of the investment fund.
A "conflict of interest" is a matter in respect of which a "reasonable person would consider the 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.". According to the Commentary to the Instrument (the Commentary), this includes inter-fund trades, transactions in securities of related issuers and purchases of securities underwritten by related underwriters, and extends to any proposed course of action that a fund, a manager or an entity related to the manager is restricted or prohibited from proceeding with by a conflict of interest or self-dealing provision contained in securities legislation.
An "entity related to the manager" includes agents of the manager and extends to the third-party portfolio managers or advisers, sub-advisers of a fund, as well as persons or companies who can "materially affect" the management and policy of the manager. Portfolio managers' decisions made on behalf of the fund that may affect the manager's ability to make decisions in the best interests of the fund are caught, but conflicts of interest at the service-provider level generally do not trigger regulation by the Instrument. Examples of what might be captured in this context include portfolio management processes allocating investments among a family of investment funds, and certain trading practices such as negotiating soft dollar arrangements.
The Instrument requires managers to create written policies and procedures to be followed when they are confronted with an actual or perceived conflict of interest. Such policies must also set out the applicable internal process for referring matters to the IRC for review or approval. Managers of more than one investment fund may establish blanket policies and procedures for all, or separate ones for each. Records of any activity subject to the review of the IRC must be maintained, and any such matters submitted to the IRC must be accompanied by information sufficient for the IRC to properly carry out its functions. In addition to implementing their own policies and procedures, managers are also expected to make reasonable inquiries about the policies and procedures implemented by their portfolio managers and advisers in respect of possible conflicts.
Certain conflict of interest matters must be approved by the IRC before the manager may proceed: for example, inter-fund trades, transactions in securities of a related issuer, or an investment in a class of securities of an issuer underwritten by an entity related to the manager. All other conflict of interest matters, though not subject to formal approval, must be submitted to the IRC for review and a recommendation as to whether the proposed action achieves a fair and reasonable result for the investment fund. The Instrument requires the manager to at least consider the IRC's recommendation in relation to these types of conflicts. Although IRC approvals or recommendations are generally provided on a case-by-case basis, a manager can act on standing instructions permitting it to engage in a particular conflict of interest action on a continuing basis on terms and conditions imposed by the IRC.
Unfortunately, the CSA did not see fit to impose a materiality or significance threshold in connection with the fund manager's obligation to refer conflict of interest matters to the IRC, with the Instrument providing that all conflicts be referred to the IRC for review or approval, as the case may be. That having been said, the definition of "conflict of interest matter" imposes a "reasonableness" standard which, according to the Commentary, denotes an exclusion of inconsequential matters. In determining what conflict transactions need to be reviewed by the IRC, managers are directed to follow industry best practices, which will emerge over time.
Appointment and composition of the IRC
The manager may appoint one IRC for all of its funds, or for any group of funds that it manages. Managers of investment funds may also share an IRC with other investment fund managers. This will very likely result in the emergence of a cottage industry of third-party IRC service providers.
The CSA expect the size of an IRC to be consistent with its workload, the minimum size being three members, all of whom must be "independent." A member is "independent" if he or she has no material relationship with the manager, the investment fund or an entity related to the manager. The Commentary sets out examples of individuals who would and would not qualify: for example, a person who is or has recently been an employee or executive officer of the manager (or is related to a recent former employee or executive officer) is unlikely to qualify; a member of the board of directors of a manager (whether independent or not) is also unlikely to meet the "independent" standard required for membership of an IRC (although a former independent member might). In certain circumstances, an independent member of the board of an investment fund may be considered "independent." For investment managers who have and wish to retain independent board members, the requirement to appoint a separate, independent IRC may seem duplicative.
The Instrument requires the manager of the fund to appoint the fund's first IRC. Subsequent appointments are in the sole domain of the IRC, which has the power to appoint new members or reappoint existing members to fill vacancies. Members of the IRC can be removed from office either by a majority of the IRC or by a majority of the securityholders of the investment fund voting at a special meeting convened for that purpose. In filling a vacancy or reappointing a member, the IRC is required to consider the fund manager's recommendations. To promote continuity and independence, a member of the IRC may serve for terms ranging from a minimum of one to a maximum of three years (the CSA recommends staggered terms of office). Consecutive terms may be served, but these may not exceed six years unless agreed to by the manager.
Liability and Indemnification of IRC members
The Instrument imposes a duty on the IRC to "act honestly and in good faith, with a view to the best interests of the investment fund." To assuage concerns about potential liability of IRC members, the CSA have taken steps to clearly define the functions, duties and obligations of the IRC (emphasizing its very specific and limited role), with a duty of care owed to the investment fund only. Further, the Commentary notes that the IRC is generally only required to consider matters referred to it by the manager. The CSA have concluded that exposure to liability should be commensurate with the narrow mandate of the IRC to review and make recommendations on conflicts of interest, and that any defences available generally to corporate directors should also be available to IRC members. The investment fund is required to indemnify IRC members for costs and expenses associated with the defence of an action, provided there has been no fault or omission on the part of the IRC member, who must also have acted in good faith, and, in the case of actions enforced by a monetary penalty, in the reasonable belief that his or her conduct was lawful. In addition, the Instrument permits the fund and manager to indemnify or purchase insurance coverage for IRC members even if they are not absolved from fault or omission, subject to the same good faith conditions as apply in respect of the mandatory indemnity cover. The CSA expect any such coverage to be on reasonable commercial terms.
The IRC's written charter
The IRC is required to adopt a written charter setting out its mandate, responsibilities and functions. Funds within a family are not required (but are permitted) to have separate charters. Although the Instrument permits the IRC broad discretion to tailor its written charter to its own particular circumstances, the CSA do indicate that they expect the written charter to include policies and procedures to be followed when reviewing conflict of interest matters, criteria regarding compensation and expenses, and policies relating to ownership by IRC members of securities of the investment fund, manager, or company that provides services to the investment fund. The Instrument requires the IRC to consider the manager's recommendations in formalizing its charter, which may include additional functions to those prescribed by the Instrument and securities legislation (bearing in mind that any such additional functions are not regulated by the Instrument).
Compensation, fees and expenses
The fund is obliged to pay all reasonable costs and expenses incurred by the IRC from the assets of the fund (which may, in turn, be reimbursed to the fund by the manager). The manager is required to set the initial compensation of the IRC. Thereafter, the Instrument grants the IRC sole authority to set its own reasonable compensation going forward; however, it must take into account the manager's recommendations in doing so. If the IRC fails to follow the manager's recommendation on the amount and type of compensation, this must be disclosed in the annual report to the securityholders, giving reasons and describing the process and criteria it applied.
Reporting requirements of the IRC
The IRC is required to report on the adequacy and effectiveness of the policies and procedures on conflicts matters on an annual basis. Focusing on both substantive and procedural aspects, this assessment must include a review of the effectiveness and adequacy of the manager's conflicts policies and procedures, and a consideration of its own effectiveness (including an assessment of the independence and compensation of its members). Written results of the assessment must be delivered to the manager, along with recommendations on any changes that should be made to the manager's policies and procedures.
In addition, the IRC must prepare an annual report to securityholders describing the IRC and its activities during the year. If the IRC is of the view that an action by the manager is not fair and reasonable, or if the manager proceeds with an action in relation to which the IRC did not give a positive recommendation, this must be reported. The annual report to securityholders must be filed with the securities regulatory authorities no later than the date on which the investment fund files its annual financial statements, and must be made available and prominently displayed on the investment fund or manager's website.
The Instrument also imposes a positive duty on the IRC to report to the securities regulators any instances where a manager has failed to comply with a condition imposed by securities law or the IRC in respect of a conflicts matter requiring IRC approval. The CSA has indicated that it will treat any such failure to comply as a breach of securities legislation, exposing the manager to regulatory action, which could include unwinding the transaction. The IRC also has authority (but is not obliged) to communicate directly with the securities regulators as and when it sees fit on any other matter.
Implementation and Transition
The Instrument has been or is expected to be adopted as a rule in British Columbia, Alberta, Manitoba, Newfoundland and Labrador, Nova Scotia, Ontario and New Brunswick. It will be adopted as a commission regulation in Saskatchewan and as a regulation in Quebec. It is expected to come into force on November 1, 2006. A one-year transition period is contemplated so that, although managers must appoint an initial IRC for a fund by May 1, 2007, the Instrument will not apply to the fund and manager until November 1, 2007. A fund manager can, however, elect to have the Instrument apply earlier by giving notice to the fund's principal regulator and thereby take advantage of the exemptive relief available for certain conflict of interest matters.
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