Proposed NI 81-107 needs work
IRCs lack real authority

There is a seemingly endless list of proposed laws in the investment industry that require comment. Recently, I was encouraged to add my feedback with respect to National Instrument 81-107, which was proposed by the Canadian Securities Administrators (CSA). Its intent is to improve investor protection in mutual fund while fostering market efficiency. In my opinion, I don't think this proposed legislation will accomplish its intended tasks. Here are highlights from my formal submission.

Overview

Proposed National Instrument 81-107 proposes to replace a number of the existing rules and regulations pertaining to conflict of interest issues in mutual funds. The solution: a regulatory framework that requires fund managers to simply refer conflict of interest matters to an appointed independent review committee (IRC). The IRC would review a matter, assess it, and make recommendations to the fund manager. However, the final decision would lie with the fund manager - effectively giving the IRC no real powers.

This implicitly proposes to move from the current rules-based system to a principles-based regulatory framework. This means that rigid rules and regulations would be replaced with broader principles and concepts. In my view - and considering the lack of evidence supporting the superiority of a principles-based system - the shift is too abrupt for my taste. A better balance between rules- and principles- based regimes seems like a better, more logical step.

Term of IRC members

While 81-107 proposes a term of two to five years for each IRC member, an interesting section proposes that the term for all members can effectively be terminated in the event of a change in manager. The specific term 'manager' is not defined in the Ontario Securities Act, but two other similar terms are defined therein. The definitions of other similar firms include 'a person' - which could mean that a change in individual lead manager (even if with the same firm) may effectively end the term of IRC members.

In short, there is potential - in my opinion - for fund sponsors to manipulate this rule to their advantage where they wanted to effectively terminate the entire IRC (if they hypothetically didn't see eye-to-eye). This is clearly not the intent of the CSA, so this is a potential loophole, and one reason why this instrument still needs work.

Disclosure

Where a fund manager makes a decision that is not consistent with the recommendations of its IRC, proposed 81-107 simply states that the nature of the 'disagreement' (and the reasons for not following the IRC's recommendations) must be disclosed in the prospectus. However, as investors know all too well, the mutual fund prospectus is a thick and intimidating document. Simply burying additional disclosures into an already daunting document is not an effective investor protection tool. This disclosure measure is egregious when considering that the Joint Forum is still contemplating a policy change that would require the distribution of prospectuses only upon specific request. So, many investors may not ever find out about fund manager and IRC disagreements.

Manager changes

Manager changes happen all the time - particularly in a world of mergers and acquisitions. However, I have witnessed over the years what I feel to be questionable manager changes in some instances where a fund company will fire an inherited relationship with an outside manager to hand over the management contract to an affiliate - or to simply bring it in house.

Proposed 81-107 wants to specifically exempt a fund manager from having to refer a change in managers to the IRC where the new manager is an affiliate. However, handing business over to a related firm is exactly the type of business conflict that 81-107 is supposed to address. Instead, it's actually proposing to exempt such a move from independent scrutiny.

Other changes

There are other changes proposed by 81-107 relating to trades between funds of the same family and what constitutes 'independent' (among other things). While I fully support the CSA's intent and the spirit in this proposed Instrument, I think 81-107 needs to go back to the drawing board. Ironically, some fund companies feel that it goes too far in tying their hands while investor activists think it actually waters down the existing regime. I would lean closer to the latter camp.

My full submission can be viewed at www.danhallett.com