THE STROMBERG REPORT PAGE

Legal Update - February 2005

THE STROMBERG REPORT: a proposed framework for mutual fund regulation

Purpose of report

"Regulatory Strategies - Recommendations for Regulating Investment Funds in Canada" (the "Report") was prepared at the initiative of the Ontario Securities Commission by Glorianne Stromberg and has now been presented to all of the Canadian Securities Administrators ("CSA").
The Report is essentially a personal analysis which addresses faithfully its terms of reference. These contemplated a review of the fund industry to determine whether there is a need to make changes in how investment funds and the offering and sale of their securities are currently regulated. The terms of reference required Commissioner Stromberg to identify:

issues requiring regulatory response;

regulatory changes required;

the role of self-regulatory organizations;

resources required by the CSA; and

steps to make CSA regulation of funds more efficient.

The Report is the first comprehensive public sector analysis of the Canadian investment fund industry since the publication of the Report of the Canadian Committee on Mutual Funds and Investment Contracts in 1969 (the Canadian Committee Report). Its relatively informal style allows it to address a surprisingly wide range of issues in both its analysis and recommendations. While the ultimate impact of the Report cannot be predicted at this date, there is no doubt that many of the recommendations will be highly controversial, not only in the fund industry, but in the public sector as well.

Dedicated regulatory structure

One of the Reportís major recommendations stems from Commissioner Strombergís assessment that the existing regulatory structures need to be changed to better serve the marketplace. The Report states that there is no question about the need to streamline the regulation of investment funds. Industry participants will applaud the statement that this means "finding ways to eliminate duplicative prospectus filing and registration requirements". It will startle many, however, to learn that this is to be accomplished by centralisation, as opposed to reciprocal arrangements between the members of the CSA.
The Report proposes the establishment of a central commission (the Central Commission) which would operate as an ordinary business corporation and be jointly owned by the twelve members of the CSA. It would be accountable to each provincial and territorial government through the relevant member of the CSA.
The functions of the Central Commission would be:

to develop all regulations, rules,and policies for funds;

to propose legislative changes;

to handle all investment adviser registrations associated with funds;

to handle all functions relating to the registration of service providers to funds and their managers;

to handle all functions relating to prospectuses and continuous disclosure filings;

to regulate a new national self-regulatory organization ("SRO") to which all persons selling securities would be required to belong; and

through an associated board of Commissioners, to hear appeals from staff decisions, participate in policy and legislative changes,and hear appeals from the SRO.

The Central Commission would be fully staffed, self funded, and would be supported by modern information systems linking it with the members of the CSA and the SRO.
Although a further recommendation of the Report calls for co ordination of the activities of all regulators having jurisdiction in the fund industry through a Joint Regulatory Co-ordination Group, it should be noted that the Central Commission proposal does not contemplate (nor even address) federal participation and thus is completely distinct from recent studies and discussions relating to a federal securities commission.
The final major component of the Reportís dedicated regulatory structure proposals is the establishment of the SRO. The Report proposes a structure that would be based on the U.S. model of the National Association of Securities Dealers, Inc. (NASD). The principal objective of the SRO proposal is to establish a level playing field for all those selling securities, not simply those selling mutual funds. The SRO would operate on similar principles to the NASD. The relationship between the SRO and existing self regulatory organizations is not addressed.

Modified disclosure regime

According to the Report, a major concern of investors and others with the current regulatory system is that, although information about a particular mutual fund is available to investors in a prospectus and financial statements, it is not available in an easily accessible format and, sometimes, does not reach investors at all. The concern that investors are not fully informed about their purchases was one of the primary reasons for the Report. The Report, therefore, contains specific recommendations for a revised disclosure system which are intended to address this concern.
The revised disclosure system would consist of one generic investor education document and three levels of investor information, comprising a base disclosure document, continuous disclosure documents, and a point of sale disclosure document.
It is proposed that the "investor education document" would provide a generic explanation of how mutual funds work and how investors can obtain further information concerning specific funds. It would be given to all investors seeking any information about mutual funds. It is proposed that the investor education document would contain information about financial goals and risk tolerance and that it would include generic tax information, including information about registered investment plans. The document would be prepared with the input of industry participants and regulators, and it would be reviewed and updated periodically. Information contained in the investor education document would not have to be repeated in documents prepared for specific funds.
The "base disclosure document" for a specific fund would contain the information which must now be included in the simplified prospectus and annual information form for a fund pursuant to National Policy No. 36, without duplicating the information contained in the investor education document. The basic disclosure document would only have to be renewed once every three years unless the Securities Regulator required an earlier re-filing because of the number of amendments made to the document during the interim period. The base disclosure document would have to be amended to disclose any material changes to a mutual fund. The Report points out that the current definition of material change and material fact in securities legislation is not suitable in the context of an investment fund, as there may be significant changes or facts in relation to a mutual fund which would not be expected to affect the market price or value of the securities of the fund. The Report, therefore, recommends the development of definitions of the terms material change and material fact in relation to the affairs of an investment fund.
The Report suggests that a somewhat more onerous continuous disclosure requirement be applied to investment funds than is currently the case. It recommends that the annual report of an investment fund be required to contain a discussion and analysis (MD&A) by management of the operations of the investment fund. The Report lists examples of information which might be included in the MD&A, including information regarding portfolio management strategies, the mutual fundís performance for the current year in comparison with its performance during prior years, an analysis of expenses, a discussion of trends and events that are reasonably expected to affect investment fund performance, and other matters. Annual reports would also be required to include disclosure about related party transactions during the year.
The Report recommends that the time period for delivering and filing annual and interim reports be reduced to 60 days after the end of a fiscal year for annual financial statements, and 45 days after the end of an interim period for interim reports.
The Report recommends that a new point of sale disclosure document be prepared for each investment fund. Although the Report stipulates that the document should be kept short and should be written in a plain and simple style, it goes on to set out a long list of information which would have to be included in the document. It is also recommended that a standard format be developed for this document so that an investor can easily compare information among funds. The Report suggests that a central electronic filing facility should be established and maintained by the investment fund industry to ensure that the latest version of these point of sale documents are available for all funds at all times.
The point of sale disclosure document would be divided into two parts. It is proposed that the first part of the point of sale disclosure document be prepared by the fund manager. It would include a description of the type of fund, the risk profile of the fund, and full details about fees, charges, and other expenses that will either be charged to the fund or directly to the investor. Examples must be given if there is a variety of sales charge options. Information would also have to be provided about the net asset value per security of the fund both at the beginning and end of a specified period.
The second part of the point of sale disclosure document would be completed by each distributor and would contain details of all sales charges, transaction charges, and any other type of fee or charge that the distributor or the sales representative may receive.

Enhanced registration and proficiency requirements

Registration of investment fund managers
The Report proposes that anyone that is acting as a manager of an investment fund, which would include any entity that is providing an investment fund with management or administrative services, either alone or in conjunction with the provision of investment advice, and regardless of whether such services are provided directly or through third parties, be required to be registered as an investment fund manager with the securities regulatory authorities in each province or territory or the proposed Central Commission (collectively, Securities Regulator).
The Report recommends that investment fund managers be required to comply with minimum capital requirements. The Report recommends that the CSA consider a scale based on a minimum capital requirement of $1,000,000 for fund assets less than $100 million, which minimum would increase as fund assets increase. The Report acknowledges that consideration must be given as to whether any reduction in the capital requirements is appropriate where the services provided by the investment fund manager are out sourced.
The Report proposes that investment fund managers should also be required to satisfy or implement various other regulatory requirements including minimum bonding and insurance requirements, internal control procedures, and the establishment of adequate disaster recovery systems.
The Report recommends that, as a condition of registration, investment fund managers should adopt a code of ethics and business conduct, and monitor and assess their compliance with standards of sound business and financial practices that are to be developed.
The Report further recommends that investment fund managers be required to satisfy certain managerial and supervisory requirements including the following:

the board of directors of an investment fund manager should consist of at least five persons, a majority of whom should be outside directors;

an audit committee of the board of directors of an investment fund manager should exist with a majority of the committee consisting of outside directors; and

delegation of functions by an investment fund manager may only occur if the manager remains accountable to the investment fund for the functions so delegated.
Registration of service providers
The Report proposes that firms that perform services for investment funds, investment fund managers or distributors of investment funds be required to register as service providers and that all such registrants be subjected to periodic audits. The types of services for which registration would be required include the following:

registrar and transfer agency services;

order entry services;

order processing services;

trustee services for RRSPs, RRIFs, and other tax-related plans; and

administrative and custodial services made available to investors for pre-authorized purchase plans and similar plans.

Proficiency requirements for industry participants
The Report recommends that a joint industry and regulatory task force be established to deal with the need to improve education and training and to raise the proficiency skills of industry participants. The items to be considered by the task force include the following:

the identification of the requisite skills for mutual fund dealers and their sales representatives;

the establishment of objective criteria to be satisfied by the proficiency requirements, with core requirements being common to all recognized courses;

a continuing review of the courses to take into account changes in regulatory requirements and new products;

an increase in course content related to securities regulatory matters, business ethics, rules off air conduct and business practices, and conflict of interest issues;

the establishment of a common examination;

minimum standards for in-house training and provision for at least a six-month period of apprenticeship; and

a mandatory continuing education program.

The Report also states that persons who propose to offer special advisory or financial planning services should not be able to do so before they have completed appropriate courses and been supervised for at least five years by an adviser or financial planner who has the requisite proficiency and experience requirements.