Who watches the watchers? Best practices for independent review committees

The review suggested IRCs broaden their definition of conflicts of interest and refresh their ranks more frequently.

However, “nothing really suggested there was widespread non-compliance,” said Michael Holder, managing director and CEO of North Star Compliance in Toronto. “So I think managers can see this as an opportunity to incrementally improve their processes.”

Nicholas Badeen, counsel in the Financial Products & Services Group with Stikeman Elliott in Toronto, said the review was warranted because the fund industry has changed dramatically since November 2006, when the national instrument governing IRCs took effect.

Examples of changes include the emergence of ETFs, liquid alternatives and cryptocurrency, as well as the modernization of investment funds in general.

Yet until now, “there hasn’t been that much guidance for IRCs from the regulators,” Badeen said.

Holder sees the IRC guidance arising from the review as related to regulators’ growing focus on conflicts of interest. “It makes sense to put the other piece of bread on the sandwich and look at how funds are doing in terms of their duties,” he said.

What makes a great IRC

A strong IRC starts with strong members.

The key is “building out a well-balanced group of individuals with the right backgrounds” in relation to the fund’s mandate, Badeen said. Industry, regulatory, financial, product and previous IRC experience is valuable.

“When [the national instrument] came out, no one had IRC experience,” Badeen said. “But now that it’s been around for awhile, you’re much more able to find someone who’s been on another IRC before.”

Holder recommends creating a skills matrix for current and prospective IRC members that identifies desirable attributes, including length of terms on other IRCs and length of time in the industry.

Badeen and Holder also emphasized the importance of creating a clear governance framework and a detailed charter, especially as IRCs can evaluate only the conflicts brought to their attention.

“Make sure that your processes and your charter actually reflects the potential conflicts in your mutual fund complex, especially operational conflicts,” Holder said. “IRCs are not boards. They do not have a supervision duty; they have a referral duty.”

“The identification of new operational conflicts should be ongoing. [Fund managers] should have a disciplined, established and organizational approach to identifying such conflicts (e.g., through regular meetings planned for this purpose) and remain aware of when IRC approval or exemptive relief is otherwise required,” Badeen and colleague Halyna Chumak wrote in a blog post.

Regardless of an IRC’s strength, its ranks must be refreshed at prescribed intervals.

In their review, the OSC and AMF found most IRCs had at least one IRC member with a term longer than six years — the maximum set out in the national instrument without needing approval from the fund manager. In “limited instances,” the review stated, members served longer than 14 years.

The regulators stated that IRC membership should not be indefinite, and exceeding the six-year term limit “should not become common practice.”

Holder acknowledged the value of long-serving IRC members. “It takes a long time to understand the specific issues and structure [of a fund],” he said. However, by staggering committee members’ terms, “you always have some legacy institutional knowledge on the IRC.”

The flip side of long service, Holder added, means “you will always be biased toward your prior decisions. If the majority of people have been making the same decisions for a long period, with no fresh eyes on their ideas and views, it may not reflect current thinking.”

Jean-Paul Bureaud, executive director of investor advocacy group FAIR Canada, agreed that exceeding the term limits could create challenges.

“If you have somebody who’s being compensated by the fund manager for a long period of time, you worry [if] they’re going to really be looking out for the interests of the unitholders,” he said.

Limits to an IRC

The IRC “is part of a multi-layered set of protections for investors,” Holder said. “It is an independent body whose duty is to make sure the manager is doing what the manager must do.”

Badeen believes IRCs strike a balance between providing oversight and not bogging down fund operations.

“When fund managers are launching new products or deciding whether to do one thing or another, they have conflicts to consider,” Badeen said. “They realize they have to put things before their IRC, and that does require them to think about things more. They have to present their case, which helps them go through the processes to make sure they’ve done things properly.”

However, an IRC “is really self-regulation,” said Ken Kivenko, president of investor advocacy group Kenmar Associates. He believes a board of directors — as is required for U.S. mutual funds — would be more effective.

Kivenko said IRCs are not empowered to address pressing investor-protection issues, such as closet indexing, greenwashing and the practice of paying trailing commissions to discount brokerages that aren’t providing advice.

“What’s an IRC going to do with that?” he said. “Are the IRCs doing their limited role? I suppose so, since there are no scandals.”

Bureaud said the U.S. director model has the potential for issues as well, especially as directors — like IRC members — are paid by the fund manager.

“Every structure has its pros and cons,” Bureaud said. “The real issue is whether the fund manager is escalating all the conflicts it should be.”

Badeen acknowledged that an IRC is stymied if fund managers aren’t transparent or forthcoming.

“If you have a bad actor, the IRC can only go so far in cases of fraud and the like,” Badeen said. “There’s limited avenues to what an IRC can do…. They can’t recommend against something that isn’t brought to their attention. And maybe there are some situations where IRCs should be asking more questions.”

Bureaud hopes the regulators continue to review IRCs. “It would be interesting to see if they would actually review the assessments made by the fund manager themselves as to what conflicts they did escalate, and whether they caught as many as they should have,” he said. “That might help to give more confidence [as to whether] the system is working well in practice.”

In general, IRCs “perform a really important function, because they are putting themselves in the shoes of unitholders,” Bureaud said. “They play an important role in the broader consumer protection framework. But could they be better? Yes.”