Last month the Ontario Securities Commission released OSC Staff Notice 33-743 titled Guidance on Sales Practices, Expense Allocation and Other Relevant Areas Developed from the Results of the Targeted Review of Large Investment Fund Managers.
The document stems from reviews of a sample of large investment fund managers "to assess their compliance with securities law." These weren't little companies that were reviewed. They had more than $500 billion in assets.
Don't let the title put you to sleep. While the document covers a range of issues including minimum working capital requirements, trust accounting and fund accounting, it includes some interesting guidance on what investment managers should not be doing if they want to be compliant with regulatory requirements in the areas of sales practices and conflicts of interest. The papers states that "Aside from the issuance of deficiency reports, the sweep did not result in further regulatory action on any of the IFM [investment fund managers] reviewed."
In some cases this guidance is expressed as a Q&A. For instance, in attempting to explain what expenses investment fund managers can and cannot charge to an investment fund, the OSC uses the following example:
"Q: We organized a party for an employee in the fund accounting department. Would it be appropriate to include this cost as part of the fund accounting department expenses that are allocated to the funds?
"A: No, these expenses are to be paid for by the IFM, not the funds. As a guideline, expenses that do not in any way impact the operation of the funds, such as the social event described above, costs related to landscaping, design or general maintenance of the office and gifts to staff need to be paid for by the IFM and not be allocated to the funds."
I don't know whether the commission's review actually found a fund manager who felt that it could charge landscaping or the cost of a party to the funds it managed. But my initial reaction was, how can a fund manager not understand what can be legitimately charged to a fund and what cannot?
Typically each fund will pay its own operating expenses, which include accounting, audit and legal fees, safekeeping and custodial fees, regulatory filing fees and the cost of preparing and distributing prospectuses and documents pertaining to investor communication.
The manager would pay out of its management fees its marketing and promotional expenses, its portfolio managers' fees and any costs stemming from commissions paid on a deferred sales charge basis and trailer commissions.
None of that is rocket science -- or landscaping, for that matter.
Another example pertains to the cost of research:
"Q: Our firm is both the IFM and the PM [portfolio manager] of our investment funds. We subscribe to a number of research materials to assist us in our research and analysis which is part of the investment decision making process. Can we charge the subscription fees to the investment funds?
"A: No. A PM manages the investment portfolios of the funds in return for an advisory fee as specified in the advisory agreement. Expenses incurred for the PM's research and analysis, or other costs associated with managing the funds' investment portfolios, are paid for by the PM because they are part of the costs of operating the PM's business. The answer may be less obvious when the firm has more than one role, i.e. being the IFM and PM. An IFM should consider whether it would pay for the subscription fees if the PM was a separate, unrelated entity. Since the PM is already compensated through its advisory fee which in turn, is paid out of the management fee collected from the funds, the IFM would not pay for the subscription fees."
That's straightforward enough, but it begs the question as to whether the commission actually found instances of a manager charging subscription fees to research material to a fund. If that is the case I suggest that the commission staff determine if that manager uses trading commissions stemming from fund transactions -- what are called "soft dollar arrangements" -- to pay for goods or services that would be more appropriately paid for by the fund manager.
The review also looked closely at certain aspects of sales practices including cooperative marketing practices, mutual fund sales conferences and fund manager participation in the sponsoring of dealer events. What investment fund managers can and cannot do is spelled out in National Instrument 81-105 Mutual Fund Sales Practices, which has been around since 1998. Its purpose was to discourage sales practices and compensation arrangements that raised the question as to whether the clients' interests rather than those of the sellers were being served (to quote the commentary published at the time which I prepared for IFIC).
Fund managers can pay a portion of the costs of an investor conference or seminar that a dealer puts on for investors. However, the staff notice says there was a 25% incidence rate where "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."
Staff also had concerns regarding mutual fund sponsored conferences. Fund managers are prohibited from paying travel and accommodations expenses of sales representatives, yet there was a 50% incidence rate of this occurring. Similarly, non-monetary benefits such as meals and entertainment were deemed excessive.
The staff notice does allow a fund manager to pay for travel from dinner back to the hotel "in light of the risk associated with consumption of alcohol."
