Mutual Funds: A special investigation
What they don't tell about mutual fund governance
Regulators have talked about toughening up mutual fund governance for more than 35 years. But the talk hasn't led to much action. Critics complain about a lenient regulatory climate that favours the industry, not the investor. Some fear this is the latest product of a fractured system of securities regulation where special deals are made to please individual provinces. Others say it's just a sign of the fund industry's increasing sway over regulators.
When Canada's securities agencies unveiled a new approach to regulating mutual fund companies two years ago, the effort was geared to providing more protection for investors.
But somewhere along the way from conception to reality, that spirit of reform got lost.
This January, the Canadian Securities Administrators (CSA) finally released their new rules for the mutual fund industry and their former "stand-up-for-investors" attitude was nowhere in sight.
Gone were several investor-friendly measures that had been included in the sweeping 2002 proposal -- measures that had been debated in Canada for the better part of four decades. The missing reforms included the requirement for an independent committee or board to oversee fund operations and mandatory registration for fund managers to ensure better protection for investors.
Instead of beefing up investors' rights, the new regulations talk of promoting investor protection "while fostering market efficiency" -- a nod to industry complaints that the original reform proposals were too costly and too cumbersome.
Plans to force funds to set up independent boards were abandoned. In their place, the rules call for independent committees to monitor conflicts of interest. But these new committees would have no power to stop a transaction. They could only require the manager to make its objections public.
In return for setting up these committees, the new rules envisage that existing regulations would be scrapped. Fund managers would be free to enter into transactions that are now off limits, such as trading securities between funds, even if their interests conflict with those of investors.
The changes are in stark contrast to the actions of U.S. regulators who are preparing to toughen governance standards for the industry in response to a string of abusive practices. The Securities and Exchange Commission is expected tomorrow to consider landmark new regulations that would require two-thirds of all fund boards to be independent from fund managers, including the chairperson.
Given the timing and the history of the debate, some observers say they were shocked to see proposals that so clearly favour the industry. Some fear the weak measures are the latest product of a fractured system of securities regulation where tradeoffs are made to please individual provinces. Others say the proposed regulations are the latest sign of the power of the mutual fund industry and its increasing sway over regulators.
Now, they wonder, who speaks for investors.
"One would have thought that was the role of the regulator," said Philip Anisman, a Toronto securities lawyer. "The investor perspective, the balance that reflects overall interests should be coming from the regulator, but that does not always happen."
Instead, Mr. Anisman said the history of attempts to develop regulations for mutual funds is a dramatic example of regulatory capture -- a theory that argues that as regulating organizations age, they increasingly adopt the viewpoint of the industry that they oversee.
"Investors aren't organized. What happens over time is that the regulator sees the problems presented by the industry without itself getting a countervailing view and ends up adopting rules that favour the industry," he said.
Mr. Anisman said several elements of the new rules seem to reflect industry views, such as the provision that certain fundamental changes to funds will no longer require an investor vote, but only advance notice to investors and committee approval.
"This seems to suggest that the regulators have accepted an industry position that mutual fund investors aren't interested in voting on anything and in any event are not capable of doing it, " he said.
Ken Kivenko, a representative with the Small Investor Protection Association, has seen the clout of the mutual fund industry first hand. "It's not a fair fight," he said of the consultation process.
Regulators say they are aware of the talk, but are not yet ready to respond. Wendy Dey, a spokeswoman for the OSC, the lead regulator on this matter, said Mr. Brown will address critic's comments once there is agreement among provincial regulators represented by the CSA about what should be done.
"Quite frankly, we will not be able to ignore the comments, no matter what side they are on," she said. "There is no question if [the proposed rules ] need to be tougher, they will be from our perspective . . . all aspects of the issue are under consideration."
Rebecca Cowdery, the former head of the investment funds team at the OSC, dismisses suggestions that the new rules favour funds.
"If the industry won, so did investors," said Ms. Cowdery, who now works for the industry at law firm Borden Ladner Gervais.
She said a strong push back from the industry led regulators to put aside many of the ideas outlined in the sweeping 2002 proposal. But she argues that industry opposition was justifiable.
"It was not just push back for the sake of pushing back," she said. "It was a sense that we at the CSA were asking the impossible and the unnecessary. [An independent board] would not provide any real benefit to investors. It may sound good, but it didn't at the end of the day provide any additional investor protection."
Ms. Cowdery said regulators focused on the issue of conflicts of interest because it is the one area that could benefit from independent review and it was a proposal that had a chance of being implemented.
Likewise, Tom Hockin, chief executive officer of the Investment Funds Institute of Canada, says his industry has a give and take relationship with regulators. "We always work closely with [the OSC]. They are tough though. For example, on corporate governance, we'll say we kind of feel this way and they'll say you should go further. We have this kind of dialogue."
But critics say that dialogue has produced a set of rules -- known formally as Proposed National Instrument 81-107-- that would greatly diminish the rights of investors and that should never have seen the light of day.
"I was disappointed that they didn't pull that national instrument, quite frankly, when we discovered what was happening with mutual funds in the U.S. It really surprised me," said Purdy Crawford, the prominent corporate director who headed Ontario's Five Year Review Committee on securities regulation.
His committee's report called for strong independent governance bodies at all publicly offered mutual funds that would have the power to fire any fund manager that put its interest ahead of unitholders. A committee of the Ontario legislature must review the report. When it does, Mr. Crawford expects the mutual fund recommendations will be a hot topic.
While those recommendation have been left hanging, the proposed national rule has abandoned the idea that funds need to be governed by an independent body. U.S. mutual funds have had boards of directors since 1940 and here in Canada, several studies starting in 1969 have considered the issue.
The concept proposal released in 2002 recommended independent governance agencies as part of what it called a "five pillar" approach to regulating mutual funds.
The other pillars -- registration of fund managers, product regulation, disclosure and investor rights and increased regulator presence -- were largely not addressed in the new rules, which focus on governance and anticipate the lifting of existing product regulation.
Under the proposed rules, the independent review committees are only required to vet conflicts of interest that are brought to them by fund managers, although fund companies may choose to give them more powers. If committee members disapprove of a transaction, their only recourse is to require the manager to publish their displeasure. They have no power to veto the move.
Lynn McGrade, a lawyer with industry clients who sat on an advisory group to regulators on the new rules, said the "focused" mandate of the independent committee avoids burdening funds with unnecessary and costly structures.
She said the final say on any transactions must rest with the fund manager since it is the manager that has the fiduciary duty to investors. She also doubts that any manager will go against a committee's wishes knowing that the disagreement will be public.
By far the most controversial aspect of the new rule is its plan to repeal existing legislation that bans self-dealing and related party transactions.
The idea of replacing a firm ban with independent oversight was first raised by Stephen Erlichman in his 2000 report on the industry. He introduced the notion as a kind of carrot to entice mutual funds to establish independent boards.
Now critics say the limited powers of the new committee mean that the industry is getting more freedom, without submitting its actions to true independent oversight.
Former OSC commissioner Glorianne Stromberg, who wrote a report in 1994 that called for independent fund boards, is especially upset by this issue and has encouraged others to speak out.
"It defies my understanding. I am all for negotiations and tradeoffs but the tradeoffs that were made here -- it's out of proportion," she said. "I don't think investors are any better off and it makes it clear that the manager is in charge."
Industry members counter that in today's market, rules that limit fund actions put mutual funds that are related to a dealer at a disadvantage. For example, funds are prevented from buying new issues for 60 days if they are related to the underwriter. Ending the ban will create a level playing field, they say.
In fact, some funds say the new rules go too far. They argue that all members of the committee should not be independent and suggest two-thirds is a more reasonable threshold. Likewise, they say the definition of independence is too strict and say fund managers should have the power to appoint committee members.
There also are fears that because of the U.S. scandals, regulators will get cold feet on their plans to repeal existing legislation. Industry lawyer Ms. McGrade said this would leave Canadian mutual funds with both the burden of a costly structure of an independent committee as well as a strict prohibition.
"The problem that I have as an adviser to the industry is that we have only seen one half of the picture," she said. "At the end of the day, the cost of all this governance is going to be right on the investor."
But Mr. Anisman says the independent committee model simply does not go far enough.
"The whole premise that seems to underpin this, that there can be a substitute body with a limited mandate that really isn't responsible to the people it is supposed to be protecting, seems to me to be inconsistent with the whole theory of modern governance in the corporate context."
Mr. Erlichman, who wrote a 231-page fund governance report for the OSC in 2000, said he is still waiting to see if there are additional measures to come -- such as the often-discussed registration issue -- before he passes judgment on the latest rules.
" If it is a first step to something else, I say let's see what happens. My question is whether this is not a first step, but rather this is the first and only step."
He fears there is no political will to do more in a system that requires agreement from so many interests, including individual provincial regulators.
"I would just like people to make decisions for the right reasons. I would like a decision to be made because people believe that it is the better thing to do as opposed to what I call the politically expedient thing to do -- the classic Canadian compromise."
For 35 years, numerous reports have agreed on the need for an independent body at mutual funds to represent investor interests.
"Disclosure alone is of little or no value unless there is some independent person in such that he h as not only power but also motivation or responsibility to take appropriate action."
-- Report of the Canadian Committee on Mutual Funds and Investment Contracts, Provincial and Federal Study, 1959.
"Investment funds should be required to have an independent board."
-- Regulatory Strategies for the Mid-'90s: Recommendations for Regulation Investment Funds in Canada, Glorianne Stromberg, 1995.
"We agree with the Stromberg Report recommendation that investment funds be required to have an independent board, board of governors or advisory committee."
-- The Stromberg Report: An Industry Perspective, The Investment Funds Steering Group. 1996
"Each mutual fund complex should be required to establish a governance regime that has a governing body independent from the manager of the mutual funds."
-- Making it Mutual: Aligning the interests of investors and Managers. Recommendations for a Mutual Fund Governance Regime for Canada. Stephen Erlichman, 2000.
"This concept proposal underscores our agreement with earlier commentators that a well-defined fund governance system - one that relies on increased scrutiny of fund managers by independent groups charged with looking after investors' best interests - is a desirable thing."
-- Concept Proposal of the Canadian Securities Administrators, 2002.
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