June 6, 2011

On March 25, 2010, the Ontario Securities Commission (OSC) issued Staff Notice 81-713 (Notice) regarding their disclosure review of National Instrument 81-107 – Independent Review Committee for Investment Funds (NI 81-107). The OSC reviewed independent review committee (IRC) related disclosure (including on the website of the fund or its manager) of 141 investment funds managed by 41 different fund managers. In addition, they met with members of 12 IRCs. 

The Notice focussed on four areas: (i) IRC fees and compensation; (ii) IRC composition and interaction with the fund manager; (iii) the use of standing instructions; and (iv) exemptive relief.

Summary of Practice Points

Practice points raised in the Notice included the following:

• Disclose IRC fees as a separate line item in each fund's financial statements.
• Encourage IRCs to complete an annual certification of independence.
• Disclose breaches of any IRC standing approval in the IRC Report to Securityholders.
• Consider the conflict of interest matters identified by the OSC in the Notice and whether any are applicable to your organization and require a policy and standing instruction.
• Summarize in the IRC Report to Securityholders the actual or perceived conflict of interest that each standing instruction was intended to address rather than simply identifying it.
• When applying for exemptive relief on conflict of interest matters, consult with the IRC.
• Take minutes of IRC meetings.

IRC Fees and Compensation

The OSC Notice stated that IRC fees and compensation represent a minimal portion of a fund's total net assets. Annual compensation amongst IRC members reviewed ranged between $0 and $50,000 per annum and annual compensation amongst IRC chairs reviewed ranged between $0 and $75,000 per annum. In their Notice, the OSC summarized the factors used to assess the level of compensation of IRCs and noted that they were generally consistent across the IRCs of all funds in their sample.

The OSC noted only one recurring disclosure deficiency of significance. In certain instances, IRC fees of a fund were combined in its Statement of Operations with other fees or not disclosed at all. The OSC reminded fund managers in the Notice that all IRC fees paid by the fund must be appropriately disclosed in the fund's financial statements as a separate line item.

The OSC observed that fund managers used four different methods for allocating IRC fees among the funds they manage: (1) proportionately based on the total net assets of each fund; (2) equally among their funds; (3) based on the average number of securityholders and the average number of transactions per fund and per series for the period; and (4) at least two fund managers used a complexity factor to proportionately allocate IRC fees to their funds (i.e. the more complex the fund structure, the greater proportion of total IRC fees allocated to that fund).

IRC Composition and Interaction with the Fund Manager

The OSC reviewed the composition of the IRCs. The size of the IRCs ranged between three and nine members, with most of the IRCs reviewed having three members. The OSC found that a significant number of IRC members had expertise in the financial services industry.

The mandate of almost all of the IRCs reviewed was limited to the oversight of the fund manager's handling of conflict of interest matters required by NI 81-107. A few IRCs in the sample also act as advisory boards to the fund manager and/or to the funds more generally.

The majority of IRCs consulted had IRC members who sat on only one IRC. A few IRCs had at least one member who sat on two IRCs.

IRC Independence

The OSC found only a few instances that caused them to question the independence of IRC members. For example, they questioned whether counsel that acts for the fund manager and/or the funds should act as an IRC member, given the pecuniary relationship that exists. OSC Staff indicated in the Notice that they will continue in the normal course of their prospectus and application reviews to monitor the independence of IRC members. The OSC indicated that the practice of an annual certification of independence by IRC members is beneficial and consistent with NI 81-107 and encouraged IRCs to consider this approach.

Interaction with Fund Manager

The IRCs interviewed told the OSC that IRC members generally engage in active, constructive discussions with fund managers and that their fund managers support the orientation and ongoing education of IRC members in various ways set out in the Notice.
In the Notice, the OSC noted some inconsistency in disclosure by IRCs in the IRC Report to Securityholders of transactions which did not comply with a term of a standing approval of the IRC. The OSC reminded IRCs that any known breach of a standing approval issued by the IRC is required to be disclosed in the IRC Report to Securityholders.

Use of Legal Counsel

While the majority of IRCs the OSC met with advised that they have independent external counsel on retainer, most have not needed advice from external counsel. A few IRCs specifically mentioned their reliance on independent external counsel only for establishing the IRC charter and issues related to the indemnities of IRC members.

Standing Instructions

NI 81-107 permits the IRC to issue standing instructions on specific conflict of interest matters. The OSC observed that standing instructions have been used in a variety of conflict of interest matters and found that most fund managers have standing instructions related to the following matters:

Trading with a Related Broker-Dealer	Allocation of Fund Expenses
Trading Aggregation and Allocation	Personal Trading
Client Brokerage Commissions/ Soft Dollars/Best Execution	Portfolio Management and Investment Decisions
Proxy Voting/Voting Procedures	Business Entertainment and Gifts
Fund Valuation	Related Issuer Purchases/Inter-Fund Trading
Net Asset Value/Error Correction	Changing Subadvisors or Service Providers
Trust Accounting	Excessive Trading Policy
Fund Expense Policy (including Related Party Expenses)

The Notice listed additional conflict of interest matters addressed in standing instructions the OSC observed in their review. Consider reviewing the list to determine whether any might be appropriate for your fund family.

The OSC noted that the IRC Reports to Securityholders reviewed provided a list of standing instructions issued by the IRC, however, only a few of these reports provided a brief summary of the actual or perceived conflict of interest that each particular standing instruction was intended to address. The OSC indicated in their Notice that they think this practice is beneficial and encouraged IRCs to consider this approach.

Applications for Discretionary Exemptions From the Conflict Of Interest Prohibitions

The OSC has received a number of applications for discretionary relief from the conflict of interest prohibitions in securities legislation. In each instance, the applicant has sought to rely upon IRC approval of the transaction as the basis for requesting the exemption. OSC Staff continue to encourage fund managers to advise their IRCs prior to applying for any exemptive relief. Generally, the OSC expects:

• the IRC has been informed about the fund manager's intention and reasons for applying for relief,
• the application indicates that the IRC has been consulted, and
• the application indicates the IRC's view of the relief requested.

The OSC stated that, in the limited instances when new exemptive relief has been granted, the fund manager has been able to demonstrate a compelling market need for the exemption. In each instance, the relief has generally been limited in scope, and has included conditions that address objective and transparent pricing.

Going Forward

The OSC indicated that they intend to continue to monitor fund manager and IRC practices with a view to providing further guidance as needed. They intend to continue during prospectus and application reviews to inquire about the process and criteria used by an IRC to positively recommend or approve a conflict of interest matter. The OSC stated that this occasionally may include requesting the minutes of an IRC's discussion or materials related to a matter or to speak to the IRC or its chair. With respect to exemptive relief applications, the OSC's view is that fund managers must demonstrate a compelling need or market necessity for relief and they encourage fund managers and their counsel to contact the OSC before proceeding for novel relief.