It’s been more than two years since the new rules dealing with the independent oversight of investment funds came into force.

In essence, the new level of supervision is designed to ensure that certain conflicts of interest in the management of funds offered to the public are appropriately addressed. Many smaller funds have argued, understandably, that such conflicts do not arise in their operations, and therefore impose a bur-den with little or no benefit. But consistent application may not only improve industry standards: it would likely have the effect of protecting fund managers from litigation.

The title of the new regime may not be stirring — National Instrument 81-107, Independent Review Committee for Investment Funds — but few would argue with its purpose: the promotion of investor protection while fostering market efficiency. The biggest change ushered in by NI 81-107 was the creation of a new creature known as an independent review committee.

The IRC reviews any conflicts of interest, as defined by NI 81-107, that arise out of the management of the fund and which are brought to the IRC’s attention by the fund’s manager. The IRC must then make recommendations or provide approvals to confirm that these conflicts are being resolved by the fund manager in a manner that achieves fair and reasonable results for the fund.

As is common in national instruments, regulators have the authority to grant exemptions from the instrument, subject to such conditions as they see fit: in essence, regulators can release fund managers from the requirement for an IRC. So far, only a few such exemptions have been granted and they involve very specific fact situations.

One could argue that the “quid pro quo” of NI 81-107 was the replacement of statutory restrictions intended to address conflicts of interest between funds and fund managers with a more efficient process (these continue to apply when NI 81-107 does not). Prior to the creation of IRCs, regulators granted exemptions from these restrictions on an ad hoc basis: typically, these were based on specific applications for relief (for instance, permission to buy the securities of an IPO underwritten by an affiliate).

Many larger fund groups, their managers and their unitholders have clearly benefited from the replacement of ad hoc applications for relief with IRC-approved policies and procedures. The question that managers of smaller fund companies may be asking is whether they should receive exemptions from NI 81-107, given that their situations fundamentally differ from those of larger funds. Indeed,the issues the IRC was created to address are mostly not applicable to their business and do not limit, restrict or interfere with the management of their funds. These include: the conflicts of interest that may arise in the case of interfund trading; the purchase of securities of a related issuer; the purchase of securities underwritten by a related entity; or entering into self-dealing transactions, as described and restricted or prohibited in sec. 4 of NI 81-102.

With regard to all other conflicts of interest, assuming they have been so identified by the fund manager, the fund manager is free to do as he or she wishes and need not follow the recommendations of the IRC. This may give cause for some fund managers to question whether there are any benefits in having an IRC where the fund manager need not obtain the IRC’s approval in such instances.

Such a view is overly narrow. Fund managers should see the exercise of establishing an IRC as an independent means of testing their own views in terms of addressing conflicts of interest and meeting their fiduciary duties to the funds they manage. The experience of other fund managers in referring conflicts of interest to their respective IRCs provides an opportunity to compare one’s views with those of one’s peers, and where appropriate, adopt their views, policies and procedures going forward. Until the industry has a common view of inherent conflicts of interest, which should be referred to IRCs (because they are “conflict of interest matters” within the definition in NI 81-107), any consideration of a complete exemption from the instrument is premature.

Clearly, as the issue of what constitutes a “conflict of interest matter” is a subjective test in many cases, the combined wisdom of the industry should guide the regulators. As the industry has not yet had sufficient experience under the new regime, this wisdom has not had an adequate opportunity to develop. For that to occur, both the IRCs and the fund managers must vigorously follow the annual assessment processes mandated by NI 81-107. A “going through the motions” approach on the part of an IRC, particularly in the absence of support from its fund manager, at a minimum, represents an abdication by the IRC and the manager of their respective responsibilities to the funds and the investors that are paying their fees. It certainly does nothing to meet the investor protection goal of the instrument.

@page_break@It could be argued that the failure to consider the actions of other IRCs and fund managers in terms of which conflicts are identified for consideration by an IRC, consideration that is manifested as an IRC recommendation or an IRC approval, is evidence of a failure to meet the standard of care enunciated in the instrument and leaves one open to civil liability.



Richard E. Austin is counsel at the Toronto office of Borden Ladner Gervais LLP.