Concluding that the Canadian investment fund industry could benefit from better governance may have been easy, but implementing a governance regime is proving far tougher. The regulators’ latest stab at the task continues to generate an impressive volume of feedback, but precious little consensus.

The latest version of the Canadian Securities Administrators’ proposed fund governance regime went out for comment at the end of May, with the comment period closing at the end of August. In mid-September, however, submissions were still rolling in, as the industry’s appreciation for deadlines was apparently overwhelmed by its devotion to summer holidays. But notwithstanding the lack of punctuality, many fund industry firms did get around to submitting extensive comments on the controversial proposal.

The prospect of mandatory fund governance is not contentious simply because it imposes a new requirement on fund managers’ businesses, which they are naturally reluctant to accept. It also divides fund managers and regulators along philosophical lines. Larger firms, which can more easily afford the added cost of governance, tend to support the idea, while smaller ones don’t. The latter argue that the burden falls unfairly heavily upon them.

There’s also a division of opinion among the provincial regulators that make up the CSA.
When the latest version of the rule was sent out for comment, for example, the B.C.
Securities Commission signalled its dissent by publishing a separate notice. In that notice, it voiced concern about the fact that the CSA had decided to go ahead with a fund governance regime without first carrying out a cost/benefit analysis that would demonstrate whether or not a mandatory governance regime was advisable.

The BCSC also asked for alternative governance suggestions, and sought comment specifically on whether there should be a less burdensome regime available to smaller fund managers, and/or for dealing with business conflicts (as op-posed to related-party transactions). The BCSC’s notice also hinted at disclosure as a possible alternative to the creation of independent review committees for mutual funds.

Not surprisingly, some of the firms that will be subject to the new rule have seized on the
BCSC’s dissent to voice their ongoing concerns with the CSA’s proposals. “The questions raised by the BCSC with respect to the cost/benefit analysis of the proposed [fund governance] regime restate concerns that our members have expressed from the outset of the CSA’s fund governance initiative,” observes the Investment Funds Institute of Canada, an industry lobby group, in its comment letter.

IFIC points out that the CSA decided to require fund governance before doing any comprehensive cost/benefit analysis, “effectively assuming the need for (and benefits arising from) some form of mandatory fund governance regime for all fund managers in Canada, then making a determination as to the reasonableness of costs based on this presumed need.”

IFIC notes that, while many of its members have come to accept the assumption that a mandatory governance regime is necessary and justifiable, some have not. And, it concludes, a “true reckoning” of the costs that the new regime will impose on fund managers and, therefore, ultimately on investors, is a prerequisite to an informed analysis of the proposals.

“We are particularly concerned that the most recent version of [the proposals] may reflect a movement further away from a regime developed in response to demonstrated gaps in the existing regulatory framework or based on a realistic appraisal of the actual patterns of behaviour of Canadian mutual fund investors,” IFIC says.

It notes that its members believe the BCSC’s concerns must be addressed by the rest of the CSA.

“The mere presence of a mandatory independent review committee, even one that is given significant authority and aggressive oversight responsibilities, is not a complete panacea,” IFIC cautions. “Moreover, the efficacy of such a body is likely to be even less in a regime such as ours, that does not have significant regulatory gaps.”

Inconveniently, the argument that the Canadian system doesn’t harbour any significant regulatory gaps comes on the heels of two cases of alleged embezzlement by fund managers in Quebec — not to mention the market-timing scandal that dogged the fund industry in 2004.

It is possible that some of these problems could have been averted — or at least detected earlier — with more dedicated, independent scrutiny of funds and the various players involved in their operations (manager, trustee, custodian, etc.).

@page_break@Former Ontario Securities Commission commissioner Glorianne Stromberg suggested in her landmark 1995 fund industry report that there is “something inherently wrong” with a structure in which all of a fund’s functions are carried out without some independent scrutiny focused solely on the best interests of the fund and its unitholders.

At the time, Stromberg recommended that funds should be required to have independent boards, not simply to resolve possible conflicts but also to ensure oversight of managers’ internal controls, among other things.

The CSA’s current proposal doesn’t go nearly that far, although some of the commenters worry that it doesn’t do enough to spell out just what types of conflicts the independent review committees will have to consider, and what they won’t. And a number of the comments call for the regulators to establish a materiality threshold in the rule to make that line clearer.

Fine-tuning these sorts of details will have to happen before the rule is finalized and implemented. Susan Silma, director of the investment funds branch at the OSC in Toronto (the lead jurisdiction on the CSA’s fund governance initiative), reports that the regulators will have to consider all the comments and work out their responses before the rule goes to the next step.

She allows that the rule may go out for yet another comment period before it is ultimately implemented. That will depend on the substance of the comments themselves and whether they lead to any new thinking that would constitute material changes. Silma indicates that a further comment period may be necessary anyhow, particularly as the latest version of the rule expanded its scope beyond just mutual funds to apply also to a variety of similar investment vehicles, including exchange-traded funds, labour-sponsored funds and scholarship plans.

Some would like to see the rule applied even more broadly. In its comments, the Small Investor Protection Association recommends that segregated funds and hedge funds should also be required to comply with the rule.

Most of the other comments reflect industry concerns with the proposal. And many of them raise similar issues — things such as the requirements around the composition, creation, powers and liability of the independent review committees. Some firms fret about the possibility for disputes between managers and review committees. Others worry that managers should have more say in the appointment of review committee members. There are also concerns about the committees acting as whistle-blowers, and their ability to exclude management from their deliberations.

On that count, Silma says, it’s not the regulators’ intention to freeze fund managers out of the review committees’ work. Indeed, she says, it would be impossible for the committees to operate without the managers’ involvement.

“We have tried to build in some basic governance principles,” she says, noting that many boards are increasingly adopting the practice of spending at least some time meeting away from management — in some cases, just to develop the habit; in others, because they need to do so.

“All we’ve tried to do is have some of that built into this process. And if we didn’t get the mix quite right, we’re happy to receive some feedback. But the intention is not to shut the managers out of the process, because the process won’t work without them,” she says, “We want to be sure that the independent review committee feels free both to have a discussion and to make a decision independently.”

Independent thought and decision-making is certainly a virtue. However, it also tends to make things messier. In terms of this rule, it remains to be seen whether the BCSC sticks with its independent position on the fund governance issue or goes along with the rest of the CSA.

“On behalf of Ontario, we are committed to bringing in a fund governance regime,” Silma says. “We will take into account people’s comments and consider very carefully what people have to say. But we are committed to bringing in a fund governance regime.”

The BCSC is more equivocal. Andrew Poon, media relations at the BCSC in Vancouver, says that the BCSC has yet to decide what to do on this initiative. He notes that it is still receiving comments and that it “will assess and consider what changes to the rule need to be made or other issues need to be addressed as a result of the comments received.”

Unfortunately for those opposed to the rule, a BCSC that doesn’t concede won’t do them much good if Ontario is committed to it. Still, this initiative has already dragged on for several years. There’s nothing to say that it couldn’t drag on for some more time yet. IE