"The mutual fund industry has been through a year unlike any other since prior to the adoption of the Investment Company Act of 1940…We have witnessed a period of great turmoil, outrage and shame in the fund industry. We are currently engaging in a process of cleansing, reassessment and restoration of confidence."
These remarks of the SEC's former director of the Division of Investment Management about the investment fund industry in the United States cannot be described as hyperbolic given the events that unfolded following the September 3, 2003 announcement by the New York attorney general of his complaint against Canary Capital Partners. Although the same statements cannot quite be said of the Canadian mutual fund industry during the same period, the time since September 2003 has been notable for its climate of almost constant uncertainty and change. And many of the issues that were important to the U.S. fund industry were also important to the Canadian fund industry. We describe below the fallout from the U.S. mutual fund scandals on the Canadian industry, as well as the progress of regulatory reform in Canada. We point out that this paper is current as of May 25, 2005, and therefore does not reflect any developments after that date.
OSC Probe into Late Trading and Market Timing
The media and regulatory scrutiny of U.S. mutual funds spilled over into Canada in November 2003 when the Ontario Securities Commission (OSC) asked for information about late trading and market timing practices of Canadian mutual funds. All managers of publicly offered mutual funds in Ontario provided general information about late trading and market timing in their mutual funds, and during the second and third phases of the review, a subset of Canadian fund managers provided the OSC with detailed information about specific policies and procedures and detailed trading data relating to late trading and market timing. The self-regulatory organizations for fund distributors (the Investment Dealers Association of Canada (IDA) and the Mutual Fund Dealers Association of Canada (MFDA) carried out parallel reviews of their members.
By March 2005, the OSC had announced settlement agreements with five fund managers over findings that the fund managers did not fully protect fund investors from the harm associated with "frequent trading market timing" in their funds and accordingly acted contrary to the public interest. The settlement agreements specified that measures were taken by the fund managers to protect fund investors from some of the costs that could be incurred by the funds as a result of the market timing. However, since the fund managers failed to fully protect their funds, they will make restitution of specified amounts to the mutual funds affected by market timing pursuant to distribution plans to be submitted to the OSC for approval by September 2005. Also in December 2004, the IDA announced settlement agreements with three broker-dealers and the MFDA announced a settlement agreement with a mutual fund dealer. The dealers were said to have failed to implement supervisory systems to, among other things, adequately supervise their employees and to take adequate steps to respond to "red flags" that they were facilitating institutional clients in engaging in potentially harmful market timing activities. The dealers were required to disgorge amounts defined as their gross market timing revenues and pay those amounts to the affected funds. The IDA and the MFDA also levied fines that were equal to the applicable gross market timing revenues and ordered payment of their costs of the investigation.
In announcing the settlements, the OSC emphasized that late trading does not appear to be an issue in the Canadian mutual fund industry and that the industry responded to the mutual fund trading scandals in the U.S. by promptly taking appropriate measures to deal with market timing. The OSC confirmed that no further regulatory action will be taken as a result of the trading practices probe.
Canadian securities regulation does not directly address market timing or any form of frequent trading. The OSC used the term "frequent trading market timing" to describe the strategies employed in the applicable mutual funds and defined "market timing" as "involving short-term trading of mutual fund securities to take advantage of short-term discrepancies between the 'stale' values of securities within a mutual fund's portfolio and the current market value of those securities." The IDA took a more expansive definition of the term "market timing" by also including "frequent buying and selling of units of the same mutual fund" with short holding periods as "market timing." Given the lack of prior regulatory or industry consideration of the responsibilities of industry participants concerning market timing or frequent trading, the settlement agreements provide some clarity. Many questions still remain unanswered, including when will short-term trading be considered offensive, particularly where the funds are not susceptible to "market timing" or where the more egregious factors surrounding the market timing actions in the U.S. do not exist.
With the continued uncertainty around market timing, Canadian fund managers were left to work out policies and procedures focused on market timing with little regulatory guidance. Canadian fund managers looked to the rules and the best practices that developed in Canada, the U.S. and elsewhere as a result of the U.S. scandals, including the recommendations the Investment Funds Institute of Canada made in its August 2004 Report on Market Timing and Short-Term Trading to determine appropriate methods of deterring market timers.
In March 2005, the OSC released its wrap-up report—Report on Mutual Fund Trading Practices—on its probe. Along with describing the OSC's actions and how it carried out the probe and came to its conclusions, the Report details suggested best practices for fund managers that are designed to deter market timing. The Report reinforces the OSC's view that a fund manager must have policies, procedures and other mechanisms in place to monitor trading that may be disruptive or harmful to its funds and must take reasonable steps to protect the funds from that harm. The OSC also outlined its proposed regulatory policy responses designed to "enhance overall fund compliance generally and deter frequent trading market timing practices specifically". The OSC described possible regulatory responses as including making rules to:
- require all fund managers to have a compliance program,
- require the imposition of a mandatory short-term trading fee,
- require fair value pricing of portfolio securities, and
- enhance prospectus disclosure.
Consultation on these proposed regulatory responses is expected to occur during 2005.
It can reasonably be expected that the OSC, like the American regulators, will continue to look to fund managers to take positive steps to monitor and deter market timers and will regard as unfavourable any action on the part of the fund manager that could be construed as facilitating market timing, including failing to have appropriate monitoring and detection procedures in place.
Regulatory Reform
Since the summer of 2003, the federal government, various provincial governments and the securities regulatory authorities in Canada (collectively as part of the Canadian Securities Administrators [CSA] and individually) developed close to 20 separate initiatives, all of which have had, or will have once finalized, to some degree, an impact on the Canadian investment fund industry.
These initiatives range from the big-picture debates over the structure of Canadian securities regulation—the proposals for a federal or a single provincial securities commission, provincial passport systems for securities regulation and uniform provincial securities regulation—to detailed discussions over how to improve the regulation of mutual funds and ensure regulatory compliance by advisers and fund managers.
Most of these initiatives have not been finalized; however, four developments of note were completed (or came very close to completion):
- New rules came into force on December 31, 2003, that allow mutual funds to invest in other mutual funds, provided certain conditions are complied with. The new fund-of-fund rules are a significant improvement on the prior rules, but some nuances exist that need careful consideration. For example, mutual funds can only invest in other publicly offered mutual funds that comply with National Instrument 81-102 Mutual Funds (NI 81-102); mutual funds can no longer invest in pooled funds or in exchange-traded funds (that are not themselves subject to NI 81-102), without specific regulatory approval.
- The Quebec government successfully merged the former regulators of insurance, securities and pensions together in one super-agency—Autorité des marches financiers—in February 2004. This new agency continues to participate in CSA initiatives but can be also expected to look for ways to integrate and harmonize financial services regulation in Quebec.
- The British Columbia Securities Commission (BCSC) made great strides toward a significant revamping of securities regulation in that province. Days before the expected November 2004 proclamation date of the new British Columbia Securities Act, the BC government delayed proclamation indefinitely, which meant that the new rules released by the BCSC for use under that new Act also did not come into force. No new date has been set for implementation and the BCSC continues to operate under the existing regulatory scheme.
- National Instrument 81-106 Continuous Disclosure for Investment Funds (NI 81-106) was released as a final rule in March 2005 and is expected to come into force on June 1, 2005. We describe this National Instrument in more detail below.
This paper describes the major investment fund-focused initiatives—mutual fund governance, investment fund continuous disclosure and the move by OSC staff to emphasize regulatory compliance by advisers and fund managers.
Mutual Fund Governance
In January 2004, the CSA released for comment proposed National Instrument 81-107 Independent Review Committee for Mutual Funds (NI 81-107). This long-awaited mutual fund governance rule would require a manager of one or more publicly offered mutual funds to establish an independent review committee and refer to it, for its recommendations, any matter in which the fund manager has a conflict of interest.
Improving mutual fund governance has been a priority for Canadian securities regulators for several years, although exactly what this would entail and how it would be implemented has been—and continues to be—a moving target. NI 81-107 represents the latest and most concrete step in an ongoing evolutionary process that began in the 1990s with the debate over the need for independent boards for mutual funds and increased regulatory standards for fund managers. NI 81-107 represents a modest step toward the proposed framework for regulating mutual funds and their managers suggested by the securities regulators' March 2002 concept proposal and, if adopted, will change mutual fund regulation in important ways.
NI 81-107 would require each mutual fund to have an independent review committee (IRC) consisting of at least three individuals, all of whom must be independent of the manager. One IRC could act in that capacity for all the mutual funds that are managed by a fund manager. If adopted, NI 81-107 will establish a role for the IRC that will be unique to Canada. Unlike the U.S. model of fund boards, an IRC will not have the general responsibility to oversee or supervise the management of the mutual funds carried out by the fund manager. Instead, the IRC will have a role only once the fund manager has referred a matter to it.
NI 81-107 retains the central principle of Canadian mutual fund regulation—the fund manager has the responsibility and accountability for managing its mutual funds in accordance with its fiduciary responsibilities. A fund manager must identify a range of matters relating to conflicts of interest that it must then refer to the IRC for its recommendations before taking any action in connection with those matters. The IRC must consider and "provide impartial judgment" on the matters referred to it, including the actions proposed by the manager concerning such matters, and make recommendations to the manager as to whether the manager's proposed actions would achieve a fair and reasonable result for the mutual fund. The fund manager will consider those recommendations when deciding what action to take in the matter, but ultimately will make a decision having regard to its fiduciary responsibilities to the mutual funds. However, if a fund manager does not follow the IRC's recommendations, NI 81-107 will require the manager to disclose in the funds' disclosure documents why it did not adopt them.
NI 81-107 will require a fund manager to refer matters to the IRC when its business and commercial interests could reasonably be said to conflict with its duty to act in the best interests of the mutual fund. NI 81-107 sets a broad, open-ended test for when a fund manager must refer a matter. NI 81-107 appears designed to require a fund manager to refer a matter to an IRC, if the fund manager cannot objectively determine whether it is making a decision or taking an action in connection with that matter that is in the best interests of the mutual fund, because of its other commercial or business interests. The regulators give guidance on the range of conflict matters they expect to be referred to the IRC and note that the list is not exhaustive and they do not expect every mutual fund manager to experience these conflicts. The range of conflicts is far-reaching and goes beyond the related-party transactions and self-dealing provisions that are currently prohibited or restricted in Canadian securities legislation and regulation.
NI 81-107 also would require a fund manager to refer to the IRC proposals to change its mutual funds in prescribed fundamental ways, on the theory that the fund manager is conflicted in proposing these changes. With minor wording changes, the matters that must be referred to the IRC for its recommendations are the same matters that currently must be approved by the security holders of a mutual fund as required by Part 5 of NI 81-102—including proposals to increase fees or expenses or change the fundamental investment objectives of a mutual fund.
NI 81-107 would require an IRC to consider and "provide impartial judgment" on a matter that a fund manager refers to it. The IRC will be required to recommend what action the manager should take to achieve a fair and reasonable result for the mutual fund. The IRC must carry out its responsibilities regarding the standard of care set out in NI 81-107—to act honestly and in good faith in the best interests of the mutual fund and to exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances. Under NI 81-107, an IRC member will not contravene this standard if he or she exercises reasonable judgment based on information available at the time he or she considered the matter.
The comment period on proposed NI 81-107 ended in April 2004. Over 40 comment letters are posted on the OSC's Web site, www.osc.gov.on.ca. Views expressed on NI 81-107 are polarized: consumers and investor advocates are opposed to the rule because they believe that the regulators' concept of governance is too "weak", while some industry participants remain opposed to the concept of independent oversight, since the costs of implementing and operating a governance structure are thought to outweigh the expected benefits.
We understand that the CSA have completed their consultations, including their review of the comments received and will be releasing NI 81-107 for a second comment period before the summer 2005. Given the comments received, the regulatory climate arising from the trading practices probe, actions taken by U.S. regulators to enhance fund governance and the Ontario provincial government's interest in investment funds, we expect that the revised version of NI 81-107 will reflect the regulators' re-examination of the role of an IRC and its place in existing regulation.
Investment Fund Continuous Disclosure
NI 81-106, and its related companion policy and forms, are expected to come into force on June 1, 2005. Investment funds with financial years ending on June 30 will need to pay immediate attention to the new requirements, since they will be the first that must comply with the new requirements.
NI 81-106 contains rules that will significantly change the way in which investment funds report on their ongoing operations. It will affect reporting issuers that are mutual funds, exchange-traded funds, commodity pools, scholarship plans, labour-sponsored investment funds, split-share corporations, closed-end funds and certain deferred sales financing and flow-through share limited partnerships. In some provinces, including Ontario, exempt pooled funds will be required to follow new rules. Segregated funds offered by insurance companies will not be affected by NI 81-106.
All investment funds will prepare annual and semi-annual financial statements as mandated in NI 81-106. With some exceptions, an investment fund that is a reporting issuer will also prepare annual and semi-annual management reports of fund performance and, on a quarterly basis, a summary of its investment portfolio and its current net asset value. Disclosure documents must be prepared, approved, audited or reviewed, as applicable, and filed with the securities regulators within deadlines that are shorter than present deadlines. Investment funds will have the option of sending continuous disclosure documents to all investors or only to investors who ask for them, provided prescribed investor notification procedures are followed.
An investment fund that is a reporting issuer, but that does not have a current prospectus, will be required to prepare and file an annual information form containing specified information.
Consistent with the SEC model for disclosure of investment fund proxy voting, an investment fund that is a reporting issuer will be required to prepare and disclose its policies about proxy voting and also prepare an annual proxy voting record.
NI 81-106 revokes and replaces rules that are currently found elsewhere in securities regulation of mutual funds, generally without substantive change, except to broaden their application to other investment funds. These include changing financial year-ends and auditors; timely disclosure of a material change impacting the investment fund; maintaining records of all portfolio transactions; preparing proxies and information circulars according to prescribed requirements if investor meetings are held; and calculating management expense ratios according to prescribed requirements, if MERs are disclosed.
Regulatory Focus on Compliance by Advisers and Fund Managers
Various securities commissions in Canada continued their focus on fostering regulatory compliance by advisers and mutual fund managers, most notably the OSC, but also the British Columbia and Alberta Securities Commissions, as well as the Autorité des marches financiers (the AMF, the new super-agency regulator in Quebec ). This focus can only be expected to increase, given the current regulatory scrutiny of mutual funds and their managers.
OSC compliance staff have indicated that they expect to continue to carry out "risk-based" compliance reviews of advisers and fund managers under their risk-assessment project that began in 2001. Compliance staff implemented a risk-based selection model for routine compliance examinations of advisers and fund managers designed to focus the OSC's resources on those market participants and the specific areas of their operations considered to be most risky. During the spring of 2004, the OSC asked all fund managers and advisers to complete detailed risk-assessment questionnaires, and explained that staff will use the responses to those questionnaires to populate their risk assessment model. The risk assessments of each adviser and fund manager will be used to determine the frequency and extent of compliance field reviews. Those industry participants assigned high-risk rankings will be subjected to more frequent field reviews.
Compliance staff also continued their practice of publishing an "annual report" outlining the most common deficiencies identified in the past year's compliance reviews. The most notable deficiencies noted by Compliance staff in their annual report released in July 2004 dealt with the requirements for a written policies and procedures manual that reflects the current relevant regulatory requirements.
Increasingly, regulatory attention is being paid to the operations of scholarship plan dealers; registration terms and conditions were imposed onto some dealers, and in July 2004 the staff released a report detailing the issues that staff found of concern. The OSC also continues to focus on the business structures of mutual fund dealers and outlined its issues with mutual fund dealers in papers released in June and November 2004 that, among other things, raised significant questions about the continued viability of this separate registration category.
What's Ahead for the Investment Management Industry?
We explained that close to 20 initiatives were developed over the past couple years that will have an impact on the investment management industry. It remains to be seen whether those initiatives, if finalized, will achieve a more coherent and coordinated framework of regulation—one that will allow the fund industry to continue with its primary objective of providing Canadian investors with accountable and ethical money management built on fiduciary principles and trust. It may be that the Canadian mutual fund industry will continue to operate in a climate of continued regulatory uncertainty and change for at least another year. Market timing, compliance and governance can be expected to dominate the regulatory agenda for public mutual funds for the foreseeable future. Also the resignation of the Chairman of the OSC at the end of June 2005 will require the Canadian securities industry to adapt to the new regulatory agenda of the incoming OSC leader.