The Ontario Securities Commission (“OSC”) has recently released two notices providing helpful guidance on the compliance operations of investment fund managers (“IFMs”). This guidance is contained in the 2013 annual review summary report for dealers, advisers and investment fund managers (the “Annual Report”) and a June, 2014 notice reporting on the targeted review of investment fund managers (the “June Report”).
In this post, we summarize OSC findings in its compliance reviews of IFMs as discussed in the Annual Report and June Report.
Issues respecting UDPs and CCOs
IFMs are required to maintain a control and supervisory system. A firm’s ultimate designated person (“UDP”) and chief compliance officer (“CCO”) have extremely important compliance roles. They are ultimately responsible for ensuring that a compliance system is in place to ensure that the firm, and its representatives, comply with securities law.
The UDP is responsible to supervise the firm’s compliance activities and to promote compliance.
The CCO is responsible to establish and maintain policies for assessing compliance by the firm, and individuals acting on its behalf, with securities legislation. The CCO must also monitor and assess compliance by the firm, and individuals acting on its behalf, with securities legislation.
An effective compliance system is essential to a registered firm’s continued fitness for registration. Elements include day-to-day monitoring and supervision, overall systemic monitoring, identifying non-compliance at an early stage, and allowing for correction of non-compliant conduct in a timely manner. Although the firm’s UDP and CCO serve important roles, compliance is a responsibility that extends to everyone in the firm, whether they are registered or not.
The OSC has noted the following:
- UDPs should ensure that adequate staff and resources are allocated to their firm’s compliance function, taking into account the size, nature, complexity and risk of their business.
- UDPs should communicate and reinforce to all staff that compliance with securities law is a firm-wide responsibility.
- CCOs should ensure that they have an appropriate amount of involvement, time and resources to fulfill their responsibility to monitor and assess compliance with regulatory requirements.
- Firms and their CCOs should perform ongoing self-assessments of their compliance with Ontario securities law and take action to improve their internal controls, monitoring, supervision and policies and procedures when necessary.
- Firms should provide regular training to their staff so that they understand the firm’s policies and procedures and applicable regulatory requirements. Firms should consider engaging external legal counsel or a compliance consultant to provide advice on compliance, including making recommendations to improve the firm’s compliance system.
- CCOs should continuously educate themselves on compliance and regulatory topics, such as by attending compliance-focused seminars and participating in compliance officer associations.
- Firms should appoint individuals to act as alternates in the brief absence of the CCO or UDP (such as during vacations).
- Firms should keep detailed records of activities they conduct to identify compliance deficiencies and the actions taken to correct them.
Inadequate or no annual compliance report
The OSC notes that it continues to find cases where an IFM’s CCO does not provide an annual report to the firm’s board of directors that assesses the firm’s, and its registered individuals’, compliance with securities law. In addition, the OSC notes cases where a CCO submits a perfunctory report that concludes that the firm has complied with securities law, but does not provide any support for how the CCO made his or her assessment.
Failure to provide notice of ownership changes or asset acquisitions
The OSC has expressed concern that some IFMs do not provide it with the required notice of proposed ownership changes in, or asset acquisitions of, registered firms. The OSC notes examples of:
- IFMs or registered individuals (including the UDP, CCO, advising representative, or dealing representative of the firm) have acquired 10% or more of the securities of another registered firm, or their sponsoring firm, without first providing the OSC with the required notice;
- IFMs or registered individuals have acquired a security or securities in addition to the 10% or more securities that they already own without first providing the OSC with the required notice; or
- IFMs have not provided the OSC with the required notice as soon as the registered firm knew, or had reason to believe, that 10% or more of its voting securities were going to be acquired by a non-registrant, including an officer, director, permitted individual or employee of the firm (barring exceptional circumstances, the OSC expects to receive notice of these transactions at least 30 days prior to the transaction taking place).
Inaccurate calculations of excess working capital
IFMs must meet their capital requirements in section 12.1 of NI 31-103 to maintain their registration in good standing.
To assist IFMs in correctly preparing their capital calculations, the OSC has listed below the common deficiencies identified by its review:
- the amounts for current assets and current liabilities are accounted for on a cash basis instead of the required accrual basis;
- inclusion in current assets of accounts receivable especially from related parties that are not readily convertible to cash;
- inclusion of cash that is committed to serve specific purpose (e.g., collateral); failure to add back 100% of long term related party debt to current liabilities if the debt is not subordinated;
- failure to deliver a copy of subordination agreement to OSC;
- repayment of subordinated debt without prior notice to regulators;
- if securities are listed among current assets, the appropriate market risk deduction was not calculated; and
- form 31-103 F1 is not prepared at least monthly.
Inappropriate expenses charged to funds
The OSC notes that some IFMs are charging inappropriate expenses to the investment funds they manage. This negatively impacts the fund’s investors, as it inappropriately reduces the fund’s net assets and returns. When the OSC raises this deficiency, it requires the IFM to reimburse the applicable fund(s) for the inappropriate expenses, and depending on the facts and circumstances, the OSC may take further regulatory actions, such as imposing terms and conditions or recommending suspension of registration.
IFMs should only charge expenses to their investment funds that are related to the operation of the investment funds. Some IFMs are charging their investment funds expenses that are related to the operation of the IFMs’ business and not the investment funds. Some examples of inappropriate expenses noted in OSC compliance reviews include fees for the audit of the IFM (as opposed to audit fees for the funds), and insurance premiums, professional dues and recruiting expenses of the IFM. The OSC considers these expenses to be the cost of running a fund management business and should therefore be borne by the IFM, and not its investment funds.
The OSC also has found that a number of IFMs do not properly allocate the appropriate amount of expenses between the operation of the IFM and the operation of the funds. This occurs because often there are expenses common to the operation of the IFM business and the management of the funds. This sometimes results in an over-allocation of expenses to some of the investment funds. For example, some IFMs use a single allocation rate to allocate different types of overhead expenses to their investment funds without considering whether each type of expense relates to the operation of each of the funds, and whether the single allocation rate is the appropriate rate for all types of expenses. Also, some IFMs do not have procedures to review the expense allocation methodology on a regular basis to ensure that it remains fair and reasonable to all funds.
The OSC advises that IFMs should:
- establish policies and procedures to ensure that their investment funds are only paying for expenses that are related to the operation of those funds. The policies and procedures should, at a minimum:
- address the types of expenses that are eligible to be paid by the funds;
- ensure that expense invoices are reviewed and approved by an authorized person before they are processed for payment; and
- ensure that expenses charged to the funds are only for types of expenses that are disclosed in the funds’ offering documents as being permitted expenses.
- review their expense allocation methodology for their funds on a regular basis and maintain evidence of the review. The review should cover, at a minimum:
- how each type of expense relates to the operations of the funds; and
- the factors used to determine the allocation rate for each type of expense.
- provide clear and specific disclosure in the funds’ offering documents regarding the types of expenses that will be charged to the funds.
Inadequate disclosure in offering memoranda
The OSC reviewed a number of IFMs that manage investment funds offered through offering memoranda (instead of a prospectus). The OSC noted some instances where the offering memoranda contained inadequate and/or misleading disclosure, particularly in the following areas:
- conflict of interest matters;
- types of expenses that are paid by the investment funds; and
- the method of calculating performance fees; in particular, how any hurdle rate is to be applied in the event that a fund’s performance exceeds any high water mark part-way through the year.
The OSC also noted some cases where the IFMs, who were also the distributors of the investment funds, did not recognize that certain promotional documents (such as term sheets and confidential information memoranda) provided to potential investors met the definition of an “offering memorandum” under applicable laws. In these cases, there was no disclosure of the purchaser’s right of action for damages and right of rescission.
The OSC states that IFMs should review the offering memoranda of their investment funds to ensure that they adequately and accurately disclose all material facts relating to the investment funds, including:
- the types of expenses that are to be paid by the funds in clear and specific terms;
- conflict of interest matters, such as fees paid to related parties; and
- details on how any performance fees are calculated, including how any hurdle rate is to be applied if the fund’s performance exceeds any high water mark part-way through the year.
Inadequate oversight of outsourced functions and service providers
The OSC advises that it has identified situations where IFMs do not adequately oversee their funds’ service providers. Many IFMs outsource certain aspects of their IFM operations (such as fund accounting, trust accounting and transfer agency) to third-party service providers. Some IFMs rely solely on third-party service providers and do not perform any oversight to ensure that these service providers are fulfilling their duties and responsibilities. As a result, these IFMs are not satisfactorily discharging their obligations to comply with applicable securities legislation.
IFMs are required to establish a system of controls and supervision to ensure compliance with securities legislation and to manage their business risks in accordance with prudent business practices.
The OSC advises that IFMs should:
- establish and implement policies and procedures to actively monitor the work of service providers;
- on an ongoing basis, review the quality of work performed by service providers, including:
- the calculation of net asset value;
- reports on income and expenses of the funds;
- valuation of hard-to-value securities;
- reconciliation of total number of units outstanding between fund accounting records and transfer agent records;
- security position reconciliations between fund accounting records and the fund’s custodian records; and
- trust account reconciliations.
- review exception reports and follow-up on variances;
- adequately document their monitoring of service providers;
- ensure that service providers have adequate safeguards for keeping information confidential; and
- develop and test a business continuity plan to minimize disruption to the IFM if the service providers do not deliver their services satisfactorily.
Non-delivery of net asset value adjustments
The OSC has noted that a number of IFMs did not provide the OSC with a description of net asset value (“NAV”) adjustments for investment funds that they manage as part of their annual or interim financial reporting.
An IFM is required to deliver to its principal regulator a description of any NAV adjustment made in respect of an investment fund it manages during the year or interim period (as applicable), within 90 days after the end of the IFM’s financial year and no later than 30 days after the end of the first, second and third interim period of the IFM’s financial year (as applicable). The description of a NAV adjustment must include:
- the name of the fund;
- assets under administration of the fund;
- the cause of the adjustment;
- the dollar amount of the adjustment; and
- the effect of the adjustment on NAV per unit or share and any corrections made to the purchase and sale transactions affecting either the investment fund or security holders of the investment fund.
The OSC expects IFMs to have policies and procedures in place to ensure that descriptions of any NAV adjustments made to their investment funds are delivered to their principal regulator within the required timeframe.
The OSC also encourages IFMs to also provide the following details as part of the description submitted for a NAV adjustment:
- date(s) of the NAV error;
- date of the NAV adjustment;
- total dollar amount of the NAV adjustment for each investment fund affected by the NAV adjustment;
- percentage change in NAV for each of the investment funds affected due to the NAV adjustment;
- if the NAV adjustment was the result of a material error under the IFM’s policies and procedures;
- date of the reimbursement;
- total amount reimbursed to each of the investment funds, if any;
- total amount reimbursed to the security holders of each of the investment funds, if any;
- description and date of any corrections made to purchase and redemption transactions affecting either the investment funds or security holders of each of the investment funds;
- how long before the NAV error was discovered;
- how long after the NAV error was discovered that the NAV adjustment was made;
- if the NAV error was discovered by the IFM or by another person;
- if the policies and procedures of the IFM were changed following the NAV adjustment and if so, a description of the changes; and
- if the NAV adjustment was communicated to security holders of each of the investment funds affected and if so, a description of the communications.
The major findings of the OSC in this area, in respect of compliance with sales practice requirements of NI 81-105, were:
- cooperative marketing practices did not meet the primary purpose of promoting or providing educational information concerning a mutual fund, a mutual fund family or mutual funds generally in order to be eligible for support;
- inadequate disclosure on cooperative marketing materials to indicate that the IFM paid for a portion of the costs of the cooperative marketing practice;
- inconsistent application of the IFM’s methodology to calculate primary purpose across all cooperative marketing practice requests;
- IFMs paid for expenses of the sales representatives, such as travel and accommodation;
- the non-monetary benefits relating to the mutual fund sponsored conference, such as meals and entertainment, were excessive having regard to the purpose of the conference;
- IFMs provided support for dealer organized conferences which included amounts related to meals and entertainment that were excessive having regard to the purpose of the conference
- IFMs provided support for dealer organized conferences in excess of the 10% reimbursement limit of direct costs incurred by the dealer relating to the conference;
- IFMs did not have adequate policies and procedures regarding sales practices; and
- IFMs did not adhere to their documented policies and procedures relating to sales practices.
Mutual fund borrowings
The OSC has noted that some IFMs have overdraft positions in their mutual funds’ bank accounts in excess of the prescribed 5% of NAV limit in NI 81-102.
Prohibited cross trades
The OSC has noted that prohibited trades occurred between the investment funds advised by an IFM (in its capacity as a portfolio manager) or between investment funds and other managed accounts of the IFM.