On March 21, 2024, staff of the Ontario Securities Commission and the Autorité des marchés financiers published Multilateral Staff Notice 81-337 setting out findings from their continuous disclosure review (the Review) related to National Instrument 81-107 Independent Review Committee for Investment Funds (NI 81-107). NI 81-107 requires all investment funds that are reporting issuers1, including all publicly offered mutual funds and non-redeemable investment funds, to have an independent review committee (IRC) to which investment fund managers (IFMs) must refer all conflict of interest matters. While an IRC's core mandate relates to conflicts of interest, IRCs can be tasked with additional functions as agreed with their IFMs.
NI 81-107 permits significant flexibility in how IFMs structure their IRCs, so long as that structure is appropriate for the investment funds the IRC will manage and the expected workload of the IRC. IFMs may (1) establish an IRC for each investment fund they manage, (2) establish a single IRC for all their investment funds, (3) share an IRC with investment funds managed by other managers, or (4) source IRC services from third parties.
The Review covers several specific topics concerning IRC practices and expectations, including IRC term limits, compensation, the skills, competency and recruitment of IRC members, and observations relating to the size and composition of IRCs. Some of the highlights of the guidance are set out below.
What you need to know
- Term limits for IRC members. While the traditional six-year term limit of an IRC member may be extended with the agreement of the IFM, membership beyond six years should be seen as an exception to the rule which should not be commonplace in order to preserve the independence of the IRC.
- A fair and transparent recruitment process. While Staff was largely satisfied with the criteria used by IFMs to evaluate prospective IRC members, IFMs should continue to strive to assemble IRCs through a fair and transparent recruitment process which encourages applications from individuals with diverse backgrounds.
- Compensation disclosure not required but encouraged. While disclosure of how IRC costs are distributed across funds is not mandatory, such disclosure is beneficial to investors and, when disclosed voluntarily, should be "informative, meaningful and not vague".
- When it comes to conflicts of interest, err on the side of caution. IFMs should take an expansive and "wide ranging" view of what might constitute a conflict of interest and refer any potential conflicts of interest to their IRC for their recommendation or approval.
- The IRC must publish an annual report for securityholders. An IRC's annual report to securityholders must describe the IRC's activities for the past financial year and should include "fulsome, substantive and informative" disclosure of the IRC's activities.
IRC term limits
NI 81-107 sets a maximum term limit for IRC members of six years, to be extended only with the agreement of the IFM. That said, the Review identified several instances where IRC members served beyond the traditional 6-year limit, as IFMs found longer terms more conducive to stability because members could develop valuable familiarity with the IFM's business and operations. While noting the perceived benefits of longer-tenured IRC members, Staff expressed a view that membership on an IRC beyond six years should be treated as an exception to the rule, pointing out that while these longstanding relationships can enhance familiarity with the fund, they might also compromise the independence of the insights which IRC members are meant to bring to their conflict of interest assessments.
Selecting IRC members
While IRCs are primarily tasked with conflict of interest questions, NI 81-107 sets out a variety of competencies and skills which are required to fulfill an IRC's mandate. The Review was largely satisfied with the experience and qualifications of IRC members, as well as with the criteria used to assess a candidate's ability to perform the functions required of an IRC member. Staff encouraged IRCs and IFMs to strive towards assembling IRCs composed of diverse skill sets and reminded the industry that, consistent with section 3.15 of NI 81-107, ongoing IRC education is necessary to enhance the skills and competencies required of an effective IRC. In addition, Staff reiterated the position that IRCs and IFMs should implement a fair and transparent recruitment process that encourages applications from individuals with diverse backgrounds and which is primarily led by the IRC itself, without undue reliance on candidates preferred by the IFM.
IRC composition
While IFMs can ultimately determine the size of their IRCs depending on the number and complexity of the conflict of interest matters expected to be brought before it, NI 81-107 sets a minimum three-person limit. The Review expressed little appetite from the industry for an increase to the minimum limit. While there is currently no regulatory requirement for firms to disclose the diversity of their IRCs or to establish any diversity-specific policies, Staff expressed the view that diversity in IRC composition may contribute to better decision making for IRCs, owing to wider perspectives and more diverse experiences. While diversity of skillset is of critical importance, Staff encouraged IRCs to pursue membership compositions that are reflective of multiple forms of diversity, particularly those relevant to the fund and its securityholders.
IRC compensation
Pursuant to Section 3.8 of NI 81-107, IFMs can set initial compensation for IRCs whereas the IRC has responsibility to set compensation thereafter. The Review's largest takeaway with respect to compensation was that compensation disclosure in IRC reports to securityholders frequently did not specify the basis on which IRC compensation was allocated across funds. While there is no requirement to include disclosure specifying a basis for the allocation of IRC costs, Staff noted vague references on how IRC costs were allocated, including "in a manner considered to be reasonable," "on a fair and equitable basis," or "as fair and reasonable".
The Review suggested that disclosure of how IRC costs are distributed across funds, while not mandatory, is beneficial to investors. Any such description included voluntarily should be "informative, meaningful and not vague" and should avoid the use of generic statements that are not informative and leave room for interpretation or confusion (e.g., whether an "equitable" distribution means "equally across all funds").
Staff also reminded IFMs that a breakdown of individual IRC costs must be included in the fund's prospectus going forward and should be consistent with any disclosure provided in the IRC report to securityholders.
Scope of IRC reviews
Since the onus in NI 81-107 is on IFMs to identify conflicts of interest, Staff encouraged IFMs to take a "broad and wide-ranging" view of what might constitute a conflict of interest. Pages seven and eight of the Review set out some common items which were routinely referred to IRCs for their recommendation or approval, including inter-fund trading, proxy voting, soft dollar use, and NAV errors and adjustments. It is clear from this and prior guidance that Staff expect IFMs to err on the side of caution and refer potential conflict of interest matters to their IRCs for consideration. The identification of conflicts of interest should also be an ongoing endeavour, particularly given the increasing complexity of investment fund management regulation and operations. While the scope of IRCs can extend beyond conflict of interest matters, there was no interest expressed in the Review to expand the core mandate of IRCs beyond conflicts of interest.
Disclosing the impact of IRCs
Section 4.4 of NI 81-107 requires IRCs to prepare an annual report to securityholders describing the IRC's activities for the financial year, including the names of IRC members, aggregate compensation paid to IRC members, and a brief summary of any recommendations and approvals the manager relied upon during the period, among other things. The report to securityholders is the sole document detailing IRC activities and, as such, should include "fulsome, substantive and informative" disclosure that provides a clear picture of IRC activities, including how the IRC has impacted the way in which fund conflicts of interest have been mitigated.
Takeaways
The Review produced a number of useful insights for IFMs to help enhance the efficacy of their IRCs and ensure that the IRC is meeting the expectations of the regulators. Firstly, since the effectiveness of an IRC depends on IFMs referring all appropriate matters creating conflict of interest concerns, IFMs should err on the side of inclusion and refer a matter to the IRC if there is any doubt as to whether it may raise conflict of interest concerns. Secondly, while no diversity disclosure is required with respect to IRC composition, diversity in IRC membership beyond traditional skill-set metrics may lead to better decision-making and good governance in the view of the regulators. Lastly, IRCs are encouraged to limit the terms of sitting IRC members to six years to preserve the independence of the IRC and allow room for fresh perspectives.
We are available to review a firm's policies and procedures with respect to IRCs and conflicts of interest to assess compliance with the new guidance and industry best practices.
Footnote
1. NI 81-107 does not apply to mutual funds that are not reporting issuers, such as mutual funds that sell securities to the public exclusively under capital raising exemptions.
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