Securities Regulators Provide Guidance for Independent Review Committees

On March 21, 2024, the Ontario Securities Commission (OSC) and the Autorité des marchés financiers (AMF) published CSA Multilateral Staff Notice 81-337 outlining the results of their continuous disclosure review related to National Instrument 81-107 Independent Review Committee for Investment Funds (NI 81-107). The Notice does not propose any changes to NI 81-107, but it provides regulatory views and guidance on six areas of inquiry related to independent review committees (IRCs): (i) term limits, (ii) skills, competencies and recruitment, (iii) size and diversity, (iv) compensation, (v) expanded scope of IRC review, and (vi) disclosure to demonstrate IRC impact.

A. Key Takeaways

• IRCs should aim for “ongoing turnover and fresh perspectives.” Staff of the OSC and AMF (Staff) conclude that IRC terms beyond six years should only occur in limited circumstances. Justification of extended terms may require greater disclosure.

• IRCs should consider implementing firm term limits for the role of IRC Chair.

• IRC recruitment should be fair, transparent and focused on those with relevant knowledge and experience gained from various backgrounds.

• IRCs should pursue diversity beyond skill-set in their membership, which may improve IRC decision-making and governance.

• The basis for determining IRC compensation and its allocation across funds should be disclosed in an informative and meaningful way and justified based on the IRC’s complexity and involvement.

• Investment fund managers (IFMs) are responsible for identifying conflicts of interest but should take a broad and wide-ranging view of conflict-of-interest matters. There should be an ongoing and specific focus on the IFM identifying operational conflicts, for example, via regular organizational meetings.

• An IRC should ensure fulsome, substantive and informative disclosure regarding the scope and impact of its involvement in conflict-of-interest matters in the annual IRC Report to Securityholders.

• No amendments to NI 81-107 are required.

B. Findings, Comments and Regulatory Views

The Notice provides background and a helpful summary of the requirements of NI 81-107 and the role of the IRC. The Notice confirms that the IRC is not intended to replace the IFM; rather, the IRC is intended to support the IFM and review its handling of conflicts. Staff reiterate that the responsibility for identifying and mitigating conflicts of interest ultimately rests with the IFM and not the IRC.

The OSC and AMF’s review of IRC-related disclosure included investment funds managed by 24 different IFMs, selected to ensure fair representation of fund family size and fund type. The investment funds included conventional mutual funds, exchange-traded funds, scholarship plans and alternative funds with assets under management (AUM) ranging from over C$100-billion to less than C$1-billion.

(i) IRC Term Limits

Section 3.4 of NI 81-107 provides that the term of an IRC member must not be less than one year or more than three years, but sets a maximum term of six years. The maximum six-year term may be extended only with the agreement of the IFM. This term limit is intended to ensure that the IRC is independent and effective, with turnover promoting new insights and varied perspectives on conflict-of-interest matters.

Most IRCs reviewed had at least one member with a term longer than six years. IFMs indicated that membership longer than the six-year term promotes stability and efficiency, allowing IRC members to develop specialized knowledge and familiarity with the IFM’s processes for mitigating conflicts of interest.

Regulatory Guidance: IRCs should strive for “fresh, ongoing turnover” in IRC membership to promote “new” and “independent” insights regarding conflicts of interest. IRC terms beyond six years should only occur in limited circumstances and should not be common practice, as IRC independence and efficacy may be challenged or compromised by an extensive IRC term. IRCs should also consider implementing firm term limits for the role of IRC Chair to encourage regular changes in leadership.

This guidance on the exceptionality of term limits past six years goes beyond the “comply-or-explain” regime requirements in the corporate issuer context where the securities regulators have not provided any formal guidance regarding appropriate term limits.

(ii) Skills, Competencies and Recruitment of IRC Members

Section 3.5 of NI 81-107 outlines the nominating criteria for appointing an IRC member and requires that the IFM and IRC consider the competencies and skills of the IRC as a whole and its current and prospective members.

All IRCs reviewed demonstrated knowledge, experience, competencies and relevant skills across their members. Factors that all IRCs cited as necessary for IRC members to perform their function as an oversight body include industry knowledge and experience, interpersonal and analytical skills, professionalism, and the ability to align with the investor’s perspective while providing different thoughts and perspectives.

Regulatory Guidance: IRCs and IFMs should strive for diverse skill-sets among IRC members. Recruitment should be fair, transparent and focused on those with relevant knowledge and experience gained from various backgrounds. IRCs should lead the recruitment process and not place undue reliance on the IFM’s preferred candidates.

Staff also remind IFMs that ongoing IRC orientation and education is necessary to enhance the skills and competencies for an effective IRC.

(iii) Size and Diversity

Section 3.7 of NI 81-107 requires that the IRC have at least three members but permits the IFM to determine membership to ensure effective decision-making.

All IRCs reviewed complied with the three-member minimum and indicated that this minimum size is advantageous for the IRC’s efficacy, diversity of thought and processes. Nine of 24 IRCs reviewed noted changes to their composition during the review period, indicating turnover. Most IRCs highlighted the need for specialized and diverse skill-sets as paramount to IRC efficacy.

Regulatory Guidance: Diversity beyond skill-set should be pursued to foster a variety of perspectives. Staff are of the view that wider perspectives may better inform decision-making concerning conflict-of-interest matters. While IRCs are not currently subject to any regulatory disclosure requirements concerning the diversity of their members, nor a specific regulatory requirement to establish diversity policies, IRCs are encouraged to pursue membership that reflects all forms of diversity and, in particular, those forms that are relevant to the fund and its securityholders.

(iv) Compensation

Section 3.8 of NI 81-107 permits the IFM to set IRC compensation when first appointed and cites the IRC’s responsibility to set its compensation thereafter. The results of the IRC’s annual assessment and any recommendations by the IFM must be considered. Section 4.4 requires that the annual IRC Report to Securityholders include the aggregate compensation paid to the IRC.

IRC member compensation varied widely among IFMs of different sizes with reference to AUM, though compensation was generally greater for those with higher AUM. Notably, most IRCs did not disclose the basis of IRC compensation allocation across funds, while a minority indicated equal allocation. Common criteria used to determine IRC compensation included industry annual compensation reports, comparative industry IRC compensation, workload and time commitment of IRC members, complexity of issues faced by the IRC members, results of the IRC’s annual self-assessment, nature and number of funds overseen by the IRC, inflation, economic conditions and market value of IRC members, number of meetings held or required by the IRC or IFM to address specific conflicts of interest, and industry best practices.

Regulatory Guidance: IRC compensation should be measured, justified based on complexity and involvement, and transparent concerning the basis for determination. While section 4.4 of NI 81-107 does not mandate disclosure of the basis on which IRC costs are allocated across applicable funds, Staff believe such disclosure is beneficial to investors and should be informative, meaningful and not vague. Broad statements related to allocation, such as “fair and equitable manner,” are unclear and unhelpful; clear language (e.g., “equally,” “proportionate based on the NAV or complexity of the fund,” “based on NAV of the fund,” etc.) should be used. A fund’s prospectus must also break down individual IRC costs and ensure consistent disclosure with the IRC Report to Securityholders. Disclosure of IRC compensation should be in Canadian dollars to permit meaningful comparison.

(v) Expanded Scope of IRC Review

Section 3.6 of NI 81-107 requires an IRC to adopt a written charter setting out its mandate, responsibilities, function, and policies and procedures for carrying out its functions. The IRC must review the IFM’s handling of conflict-of-interest matters that arise in a fund’s operation and may be tasked with additional functions, as agreed to with the IFM.

Most IFMs obtained standing instructions from their IRCs on certain common subjects, including proxy voting, operating costs and expense allocation, inter-fund trading, personal trading, gifts and entertainment, allocation of investment opportunities, trade allocation and aggregation, unitholder activity, and NAV errors and adjustments.

All IRCs and IFMs concluded that the IRC mandate should not be expanded beyond conflict-of-interest matters given the complexity, scope and implications of matters currently referred to the IRC and that “conflicts of interest” is sufficiently broad to capture the IRC’s role.

Regulatory Guidance: NI 81-107 places the highest onus on the IFM to identify, mitigate and refer conflict-of-interest matters to the IRC for its approval or recommendation. The IRC must be reactive to such referrals and may be proactive in its review.

IFMs should take a broad and wide-ranging view of “operational” conflicts of interest (i.e., those not specifically regulated under securities legislation except through the general duties of loyalty and care imposed on the IFM). Staff encourage a “broad interpretation of ‘operational’ conflicts of interest to derive maximum benefit from IRC review of how conflicts of interest are mitigated.” There should be an ongoing and specific focus on identifying such conflicts via, for example, regular organizational meetings.

Regarding “structural” conflicts (i.e., those for which the IFM needs IRC approval to proceed with the transaction), IFMs should know when IRC approval or exemptive relief from requirements in securities legislation is required to proceed with such transactions. Such approval may be provided on a case-by-case basis or as a standing instruction.

Staff encourage IFMs to take a broad view of what constitutes a “conflict of interest matter” and note that, notwithstanding the foregoing, there may be instances where it is appropriate for the IRC to contact a regulator to discuss any matter in connection with the subject funds, including when the IRC has found, or has reasonable grounds to suspect, that a breach of securities legislation has occurred. Staff note that this should not extend to inconsequential matters and should be used when appropriate.

(vi) Disclosure to Demonstrate IRC Impact

Staff queried whether a specific metric or additional disclosure should be used to assess the efficacy of the IRC and its impact on the IFM's handling of a conflict-of-interest matter. Most IRCs consider the current disclosure requirements of the annual IRC Report to Securityholders adequate to demonstrate its work and impact. Suggestions for additional disclosure included (a) discussions between the IRC and IFM, (b) a cover report by the IRC Chair, (c) IRC member profiles, and (d) any competency matrix used to assess skills and competencies of current and prospective IRC members.

Regulatory Guidance: IRCs should ensure fulsome, substantive and informative disclosure regarding the scope and impact of IRC involvement in conflict-of-interest matters in the IRC Report to Securityholders. For example, the report could detail any enhanced procedures the IFM adopted based on an IRC approval or recommendation.

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