Protecting the Guardians

NOTE: The views and opinions expressed are the author’s own and are in no way necessarily reflective of those of any member of the Arch Insurance Group

The inherent limitations of applying old underwriting solutions to new exposures are nowhere more evident than in the Canadian mutual fund industry, which is presently grappling with a unique governance regime that raises important considerations about personal liability. The traditional approach of responding to new exposures and regulatory structures by simply modifying existing D&O or E&O products — i.e. by changing the definition of “insured” without a proper understanding of the needs of the prospective insured and how personal liabilities are likely to manifest — has proven largely inadequate.

A BRIEF BACKGROUND

By way of background, the Canadian mutual fund industry has grown at an exponential pace. It presently makes up about 3% of the worldwide investment fund market, estimated to be valued in excess of US$19 trillion. That would put the value of assets under administration in Canada at well over Cdn$500 billion.

As the industry has expanded and matured, an increasing focus on governance has developed due to the complex legal and regulatory framework within which investment funds operate in Canada. Conceptually, the term “governance” is generally understood to mean the economic and legal relationship between the person whose assets are being managed by the fund manager (i.e. the investment fund unit holder) and the person who is managing the asset (i.e. the investment fund manager).

The issue of corporate governance has garnered mainstream attention with the introduction of the Sarbanes-Oxley Act of 2002 in the United States and similar-type regulations for public companies in Canada, but the specific structure of investment funds and the inherently “passive” nature of the investment gives rise to an additional dynamic; the unit holders of an investment fund typically occupy a different position and role than that of shareholders in a modern public corporation. As noted by one prominent legal commentator in the field, “mutual fund investors have neither the resources nor the inclination to police mutual fund managers in the execution of their fiduciary duties.”

The investment fund governance debate, as it has become known in the Canadian mutual fund industry, became audibly louder throughout the 1990s. Many prominent industry professionals and commentators sounded the alarm about the lack of mechanisms in place to check and balance the inherent conflicts that can arise in the investment fund and investment fund manager relationship. The response was ultimately a careful and methodical consideration by the Canadian Securities Administrators (CSA). The end result was the implementation of National Instrument 81-107 – Independent Review Committee (IRC) for Investment Funds, first released for industry comment in January 2004. It was subsequently revised and republished for further comment in 2005, before it was ultimately proclaimed in force, effective Nov. 1, 2006.

CHECKS AND BALANCES

National Instrument 81-107 requires every investment fund that is a reporting issuer in Canada to have a fully independent body known as an Independent Review Committee (“IRC”). The mandate of the committee is to oversee decisions that pose or have the potential to pose a “conflict of interest” vis–vis the investment fund manager. The investment fund manager is obliged to refer all matters in which a conflict of interest exists or where there is potential for conflict of interest. National Instrument 81-107 defines a “conflict of interest” to mean any matter in which a reasonable person would consider the investment fund manager or an entity related to the manager, to have an interest that may conflict with the investment fund manager’s ability to act in good faith and in the best interests of the investment fund. The commentary accompanying National Instrument 81-107 indicates such matters would include any inter-fund trades, transactions in securities of related issuers and purchases of securities underwritten by related underwriters.

Moreover, and unlike other matters referred to the IRC, these specific “conflicts of interest” must be approved by the IRC before the investment fund manager may proceed with a specific transaction. In all other instances, while the investment fund manager must refer the conflict of interest to the IRC, the IRC simply provides a recommendation as to whether proposed action(s) achieve “a fair and reasonable result for the investment fund.”

National Instrument 81-107 imposes a duty of loyalty on IRC members, requiring them to act honestly and in good faith, and with a view to the best interests of the investment fund. In addition, there is a duty of care on IRC members to exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. The duty of care imposed upon IRC members under 81-107 is expressly subject to a type of “due diligence defence.” This removes liability if an IRC member relies in good faith on a report or certification represented as full and true to the IRC by the investment fund manager or an entity related thereto or the report of a person whose profession lends credibility to a statement made by that person. Further, an IRC member will have complied with his or her duty of loyalty if he or she has relied in good faith on a report or certification represented as full and true to the IRC by the investment fund manager or a related entity or on the report of a person whose profession lends credibility to a statement made by that person.

DEFINING ROLES

In the commentary that accompanies National Instrument 81-107, the CSA has noted that it considers the role of IRC members to be similar to that of corporate directors, but with a much more limited mandate, and therefore any defences available to corporate directors would also be available to IRC members. Further, the CSA has expressly indicated it did not intend to create a duty of care on the part of the IRC members to any person other than the investment fund. This is unlike jurisprudence establishing that in certain situations, directors of a corporation may owe a duty of care to other stakeholders and not just to the corporation itself.

Similar to corporate directors, IRC members have a permissive right of indemnification. However, IRC members may seek indemnification from both the investment fund and the investment fund manager for costs and expenses — including an amount paid to settle an action or satisfy a judgment — associated with the defence of an action, provided certain conditions are satisfied. These conditions are:

* that the IRC member has acted honestly and in good faith, with a view to the best interests of the investment fund, and

* that in the case of a criminal or administrative action or proceeding enforced by a monetary penalty, the IRC member had reasonable grounds for believing the individual’s conduct was lawful.

The investment fund and the investment fund manager may also advance moneys to an IRC member for the costs, charges and expenses of a proceeding for which indemnity is granted. However, the IRC member must repay the monies advanced if the conditions imposed for indemnification under National Instrument 81-107 are not satisfied. In addition, National Instrument 81-107 permits the investment fund and the investment fund manager to purchase insurance coverage for IRC members.

QUESTIONS OF LIABILITY

National Instrument 81-107 is a true “made-in-Canada” approach to the issues associated with investment fund governance and represents both a unique and innovative solution to addressing the agency costs associated with the separation of legal ownership of an asset and its effective control. And yet, the liability of IRC members, although not as significant as that of public company directors, is not entirely benign. It could conceivably be expanded, depending upon the exact nature of the IRC’s mandate regarding its oversight role of an investment fund manager.

Furthermore, until litigation has been brought in a given particular context, it remains to be seen how the courts will interpret the obligations of an IRC member under National Instrument 81-107. In circumstances in which there has been fraud or other egregious self-dealing by an investment fund or by an investment fund manager, a court may, as a practical matter, take a more expansive view of the duties and responsibilities of an IRC member if investors suffered substantial losses and the truly culpable parties are no longer around or have insufficient assets to satisfy a judgment.

REALITY CHECK

The reality of these catastrophic loss-type situations is that lawyers will cast their nets wide in terms of arguing that the duties and responsibilities of those with an oversight role is greater because of the particular facts or circumstances at hand. Additionally, because of the concept of joint and several liability, a defendant found at least 1% liable to the plaintiff can be obligated to pay 100% of the damages, which means an IRC member’s exposure to loss is not necessarily restricted to the actual degree of culpability that he or she may bear for any losses the plaintiff sustains.

In the same way National Instrument 81-107 was created as a new solution to a pre-existing problem, existing risk transfer approaches to IRC member liability may prove to be ill-suited — and even ineffective — given the nature and structure of an IRC and its relationship with the investment fund and investment fund manager.

A reactive and traditional approach would be to assume that existing insurance and indemnification arrangements might simply be tailored to reflect the structure and needs of the IRC members. Including IRC members under the investment fund manager’s errors and omissions [E&O] insurance or director’s and officer’s [D&O] insurance would, on its face, seem a reasonable approach to risk management. However, such an approach to risk management is fraught with difficulty.

IRC members are required to be independent of the investment fund manager. Therefore, without direct control over their own insurance, their personal liability protection is subject to the control of the very interest for which they are providing oversight. Moreover, if the investment fund manager’s insurance is exhausted, rescinded or otherwise impaired, the IRC members will find themselves without coverage in circumstances in which they may require it most — namely, when there has been fraud or self-dealing by the investment fund manager or the investment fund sponsor.

Similarly, limiting the recourse of IRC members to indemnification only from the investment fund itself creates a situation in which IRC members may be practically precluded from being able to receive reimbursement. Why? Because, like most investment fund structures in Canada, the assets are held in a legal trust arrangement and the trustee may be the investment fund sponsor or an affiliate of the sponsor; those assets can be frozen if the regulator has reason to believe there have been any material violations of applicable securities laws.

As exposures and regulatory structures evolve, it is important for risk management solutions to reflect the reality of the new environment. Today, when considering the risk management issues for anyone wearing an “independent hat,” and who is required to provide oversight to ensure that investors are protected, a non-traditional approach that reflects the principles underlying that gatekeeper role in both the indemnification and insurance arrangements is necessary. In the context of National Instrument 81-107, and for IRC members in particular, that means multiple indemnification arrangements in place. It also means an insurance product that, like National Instrument 81-107 itself, reflects a real “made-in-Canada” approach.