Following the collapse of the Emerge Canada Inc. (Emerge) ETF business, the Ontario Securities Commission (OSC) has started enforcement proceedings against its manager, two of its officers, and the three members of its independent review committee (IRC). This is the first instance of regulatory action against an IRC and, undoubtedly, it will reset expectations and procedures for all IRCs in Canada.
Recap
What Transpired?
According to the OSC’s application commencing the enforcement proceedings, these are the key facts:
- Emerge launched its ETF family using the well-established model that the manager would bear most of the funds’ operating expenses in order to keep the management expense ratios (MERs) of the ETFs to a minimum. The success of this model depended on the ETFs generating sufficient management fees for the manager to pay those operating expenses. This did not happen. Instead, management fees were insufficient and, when available, were largely diverted to other purposes. As a workaround, Emerge used the assets of the ETFs to pay their operating expenses, with a promise from Emerge to reimburse those amounts (effectively creating a loan from the ETFs to the manager). The ETFs then accounted for the cash outflow as an asset (a receivable from the manager) rather than an expense that would increase its MER and reduce its returns. The cash flow problem grew until the amount owed by the manager to the ETFs reached almost $6 million.
- Approximately two years after commencing the loans from the ETFs, the manager referred the loan arrangement to the IRC as a conflict of interest matter. However, when the IRC raised concerns, the manager recharacterized its communication to the IRC as “for informational purposes” only and not constituting a conflict of interest matter requiring IRC review. At this point, the IRC members discontinued their review of the loan arrangement.
What Errors May Have Been Made by the IRC?
It appears that the fundamental error allegedly made by the IRC was its acceptance of the manager’s recharacterization of the communication as “for informational purposes” only. This then triggered multiple alleged breaches of securities legislation and the current enforcement action. According to the OSC, the IRC members should have continued their review of the conflict of interest matter and, if impeded by the manager, they should have used (or threatened to use) one or more of the following tools:
- continue to ask questions;
- retain independent counsel;
- disclose the matter to unitholders;
- contact the OSC; and/or
- resign from the IRC and disclose the reasons for the resignation.
Instead, the IRC members are charged with:
- failing to provide a recommendation on the conflict of interest matter as required by section 4.1(1) of NI 81-107;
- failing to disclose the conflict of interest matter in the annual report to unitholders;
- failing to meet the standard of care imposed by section 3.9 of NI 81-107; and
- engaging in conduct contrary to the public interest.
Lessons Learned to Date
Though the enforcement proceedings are at an early stage, the allegations in the OSC’s application are likely to have an immediate impact on how IRC members interpret their responsibilities, and how managers and IRCs communicate with each other.
Lesson #1: An IRC Cannot “Unsee” a Conflict of Interest Matter
During the formulation of NI 81-107, a policy decision was made by the Canadian Securities Administrators (CSA) that IRCs are to be “reactive”, not “proactive”. The responsibility to identify the existence of a conflict of interest was placed on managers, with an obligation to formulate a response and present both the conflict of interest and proposed response to the IRC for review. This was done by Emerge, though much too late and in a misguided manner since the loan arrangement was a prohibited transaction that could not become lawful with an IRC approval.
Once the conflict of interest was referred by Emerge to the IRC, it was the IRC’s responsibility to make a decision on whether the manager’s proposed course of action achieved a fair and reasonable result for the ETFs. It could not abandon that responsibility at the request of the manager. Once the manager presented the loan arrangement to the IRC as a conflict of interest matter, the IRC could not subsequently “unsee” it when the manager recharacterized the referral to the IRC as “for informational purposes” only.
Lesson #2: The IRC Must Respond Quickly
From the OSC’s application, it appears that the IRC conducted its review of the loan arrangement over a period of five months with only one meeting during that time. More than two months passed before the next meeting was held, during a period when the loan amount was growing rapidly. The OSC’s allegations suggest that this was too slow, and that the reaction of the IRC should have been proportionate to the urgency of the conflict of interest.
Lesson #3: If Necessary, the IRC Must Respond Firmly
When the manager did not adequately respond to the IRC’s questions about the loan arrangement, the OSC indicates that the IRC should have used (or threatened to use) various tools at its disposal to advance its review. It appears that the only actions taken by the IRC in this instance were to submit to the manager questions in writing and memoranda outlining the IRC’s concerns. Based on the gravity of the issue (in this case, the loan was prohibited by law and increasing rapidly in amount) and the manager’s responses, IRCs in difficult circumstances should consider escalating their actions by:
- retaining independent counsel;
- convening supplemental meetings to address the issue;
- noting that more detail regarding the matter may need to be included in the next annual report to unitholders; and
- if the manager still is not responding to the satisfaction of the IRC, contacting the OSC.
Uncertainty for the Near Future
The OSC’s allegations are likely to have long-term implications for how IRCs interpret and perform their responsibilities. In the short-term – at least until the case is resolved either with a settlement or a decision of the Tribunal – there will be a period of transition with uncertainty about several issues.
Are IRCs Still Reactive Only?
In the present case, the interactions began with the manager referring the issue to the IRC as a conflict of interest matter. It is easy to then follow the legal path that required the IRC to deal with it as such.
However, what would have happened had Emerge initially referred the loan arrangement to the IRC “for informational purposes” only (as it later tried to recharacterize it)? Could the IRC have taken the position that it was under no obligation under NI 81-107 to review the loan arrangement because it was not presented as a “conflict of interest matter”?
While the obligation to bring conflict of interest matters to the IRC rests on the manager, the actual existence of a conflict of interest matter is an objective test. It does not depend on the manager reaching that conclusion. Accordingly, if an IRC believes that a matter referred to it “for informational purposes” only in fact satisfies the definition of a “conflict of interest matter”, it may be obligated to treat the matter as such. This would place an onus on IRC members to decide, independently of the manager, whether any item on its agenda is a conflict of interest matter, rather than rely on the manager’s characterization. Rather than assume this responsibility and related risks, IRCs may begin insisting that the agenda include only items that the manager characterizes as conflict of interest matters, and discontinue the practice of discussing matters “for informational purposes” only.
Should Managers Limit Their Communications With IRCs Only to Conflict of Interest Matters?
It is a fairly common practice for managers to refer to their IRCs a variety of topics for information purposes only. In many cases, this characterization is valid and is merely intended to keep the IRC well-informed of the operations of the funds they oversee. However, if IRCs begin questioning the characterization of the information presented (as mentioned above), this practice could expose managers to the risk that they inadvertently refer to their IRC a topic that the IRC believes is a conflict of interest matter. In light of this risk, managers might discontinue this practice.
In some cases, managers may refer a subject to an IRC “for informational purposes only” when it is questionable whether the subject crosses the threshold for a “conflict of interest matter”. In these circumstances, managers may conclude (we believe incorrectly) that presentation of the subject to the IRC will provide the manager with a defense if the subject later is determined to be a conflict of interest matter. We believe this reasoning is incorrect. Failure by an IRC to identify an agenda item as a conflict of interest matter will not absolve the manager of its own responsibilities under NI 81-107 and instead might expose the IRC to potential liability.
Has the OSC Broadened the Meaning of a “Fiduciary Duty”?
A major component of the Client Focused Reforms was the introduction of new requirements for circumstances where the personal interests of a firm or individual conflict with the interests of a client. The result was an obligation to address the issue in the client’s best interests, with much ink spilt over whether this was the same as a “fiduciary duty” to the client.
However a fiduciary duty – which obligates one person to place another person’s best interests ahead of their own – is different from a “standard of care” – which defines the level of skill expected to be exercised.
The standard imposed on IRC members by section 3.9(1) of NI 81-107 is to:
- act honestly and in good faith, with a view to the best interests of the investment fund; and
- exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
The standard imposed in (a) above is commonly called a “duty of loyalty”, which is a hallmark of a fiduciary duty. In its application, the OSC repeatedly refers to the IRC allegedly breaching obligations (a) “and/or” (b), but we question whether there is evidence that the IRC members failed obligation (a), being their duty of loyalty to act honestly and in good faith with a view to the best interests of the ETFs, rather than only obligation (b), being their duty to exercise their powers with the degree of care, diligence and skill expected of a reasonably prudent person in comparable circumstances.
Future Regulatory Guidance
As has been the case with other recent topics (such as ESG, liquidity risk management, and even IRC operations), it is quite possible that the OSC’s experience with Emerge will prompt it to issue “guidance” on how IRC members can meet their standard of care.
Given the delicate balance that was struck when NI 81-107 was formulated and that changes to that balance will impact the availability of IRC members and their related fees, we would encourage the CSA to issue such future guidance through amendments to NI 81-107 with a public consultation process.
The CSA also should reconsider whether IRCs continue to fulfill their regulatory objective. At the outset, the CSA expressed a willingness to defer to IRCs on conditions to be imposed when dealing with conflicts of interest. However, more recently, the CSA appear to be signalling dissatisfaction with the types of conditions imposed by IRCs, and instead are reverting to regulation through prescriptive conditions. If the CSA wish to resume regulating conflicts of interest with prescriptive conditions, then the role of IRCs will be less meaningful and may no longer justify the related costs to unitholders. Public consultation also could identify what should be the future role of IRCs.
