If not for a certain eager New York state attorney general, the Canadian fund industry might have skated by with a kinder, gentler governance regime. But after an Eliot Spitzer-inspired investigation of market-timing in Canada, the fund industry finds itself facing not only tougher governance requirements but also the promise of more rules.

The Ontario Securities Commission put its market-timing investigation to bed in mid-March with the delivery of a final report (see page 16). And while the massive settlements it reached with five fund companies mark the end of the enforcement action resulting from the investigation, rule-making efforts are just getting started.

The OSC is contemplating a variety of initiatives to improve fund managers’ compliance generally and deter market-timing specifically. These include requiring managers to follow compliance plans; mandatory short-term trading fees; fair-value pricing of portfolio securities; and enhanced prospectus disclosure. These initiatives are all in their early stages but promise to add to the fund industry’s compliance burden.

While mechanisms such as short-term trading fees and fair valuing would take aim at market-timing, the industry is facing a more fundamental measure: mandatory compliance plans. When the Canadian Securities Administrators first introduced its fund governance proposal in 2002, it didn’t include mandatory compliance plans — despite the fact that they were recommended in the 2000 report the OSC commissioned from senior securities lawyer Steve Erlichman, partner with Fasken Martineau DuMoulin LLP in Toronto.

The concept of compliance plans was central to Erlichman’s recommendations. “I believe it is of paramount importance that every mutual fund complex have a culture of integrity that is fostered at the most senior levels of the organization and is inculcated throughout the organization. Although a culture of integrity can be encouraged, however, it is very difficult, if not impossible, to mandate such a requirement effectively,” Erlichman wrote in his report. “Accordingly, whatever the form of governance regime that results from these recommendations, I believe it is important that the manager, with the input of the governance body, prepares a compliance plan for each mutual fund.”

The plans Erlichman contemplated would spell out the policies and procedures that fund managers would follow to ensure they were putting unitholders’ interests first, including valuing fund assets properly and ensuring that assets are used only in unitholders’ interests (for example, when using soft-dollar commissions or voting proxies).

Given the unprecedented $200-million market-timing settlements and pending class-action lawsuits, fund managers may be wishing that this recommendation was followed. Instead, the CSA didn’t make compliance plans part of its initial fund governance proposal, nor did it add them to the second version of the proposal, which was largely designed to respond to industry fears that the initial proposal was too costly.

That’s not to say that, had Erlichman’s recommendations been followed at the time, the market-timing scandal would have been averted. But, he says, “[Had they been adopted], there’s a lesser chance that some of these actions would have occurred.”
Erlichman maintains that his recommendations made sense before the market-timing debacle — and they still make sense. “It’s unfortunate that it took this real-life example for them to be adopted,” he adds.

Indeed, regulators now appear to have jumped on the compliance plan bandwagon. In its market-timing report, the OSC suggests that a mandatory compliance plan rule would focus managers’ attention on compliance, which should “avert other practices that could be potentially harmful to fund investors” and that “the rule would strengthen the ability of fund managers and compliance personnel to enforce compliance with their policies and procedures.”

This echoes the reasoning of the technical committee of the International Organization of Securities Commissions, which published a report in February addressing the issue of mutual fund market-timing. It recommends fund managers implement compliance plans overseen by a designated senior person. It suggests this will ensure a strong focus on compliance, beyond trading practices, and will boost compliance personnel’s ability to enforce the rules.

“By applying certain measures to control abusive trading practices and setting them out in a compliance program, [fund managers] can demonstrate that they are putting the best interests of investors first and meeting their obligations to act in the best interest of investors,” it says.

While compliance plans are once again under consideration, it’s not yet clear how they’ll work — or who will be oversee them. It doesn’t appear that the compliance plan rule will be included in the CSA’s fund governance project, as Erlichman recommended. Instead, it is being contemplated as a separate initiative, says Leslie Byberg, manager of the OSC’s investment funds branch. She expects other jurisdictions to be part of the compliance plan initiative, as well.