#1喝喝 ASSEMBLÉE NATIONALE QUÉBEC The Public Finance Committee Consultation Paper Mutual Funds: Investor Protection in Québec March 2006#2Published by the Committees Secretariat National Assembly of Québec Édifice Pamphile-Le May 1035, des Parlementaires, 3e étage Québec (Québec) G1A 1A3 The Committee on Public Finance will hold public hearings beginning on 24 April 2006 within the framework of its order of initiative on the protection of investors in Québec. Individuals and organizations who wish to express their views on this matter must submit a brief to the above Committee no later than 14 April 2006. The Committee will select the individuals and organizations it wishes to hear from among those who have submitted a brief. The Committee has published a consultation paper which can be obtained through the clerk or by visiting the Committee's web site at the following address http://www.assnat.qc.ca Every brief must be accompanied by a concise summary of its contents, and both documents must be submitted in 25 copies printed on letter-size paper. Those who wish to have their brief forwarded to the press gallery must provide an additional 20 copies. Furthermore, individuals and organizations are invited to submit an electronic version of their brief in addition to the required paper copies. Please note that unless otherwise decided by the Committee, briefs will be made public, as well as all personal information contained therein, and will be placed on the Internet site of the Committee. It is also possible to express one's opinion on the subject by answering the online consultation questionnaire, available on the Internet site of the Committee on Public Finance, at the aforementioned address. Briefs, correspondence, and requests for information should be addressed to : Me François Arsenault, Clerk of the Committee on Public Finance, Édifice Pamphile-Le May, 1035, rue des Parlementaires, 3e étage, Québec (Québec), G1A 1A3. Telephone (418) 643-2722 Facsimile (418) 643-0248 E-mail [email protected] ISBN: 2-550-46616-0 LEGAL DEPOSIT - BIBLIOTHÈQUE NATIONALE DU QUÉBEC, march 2006#3Chair Με The members of Public Finance Committee Sam Hamad (Louis-Hébert) Vice Chair Με Rosaire Bertrand (Charlevoix) Mrs Members Denise Beaudoin (Mirabel) Mr Raymond Bernier (Montmorency) Mrs Nancy Charest (Matane) Με André Gabias (Trois-Rivières) Με François Legault (Rousseau) Mr Guy Lelièvre (Gaspé) Με Pierre Moreau (Marguerite-D'Youville) Με Alain Paquet (Laval-des-Rapides) Mr Marc Picard (Chutes-de-la-Chaudière) Mr Tony Tomassi (LaFontaine) Committee Clerk Me François Arsenault Research Με Jacques Gagnon, Desk Research Department Mrs Chedlia Touil, Desk Research Department Revision Mrs Danielle Simard, Desk Research Department Secretary Mrs Marie-Claude Tremblay#4Empty#532 32 22 32 ASSEMBLÉE NATIONALE QUÉBEC The Public Finance Committee Mutual Funds: Investor Protection in Québec Consultation Paper March 2006#6Empty#7Mutual funds Investor protection in Québec TABLE OF CONTENTS 1. 2. 3. INTRODUCTION.... OVERVIEW OF THE MUTUAL FUND INDUSTRY 2.1. A big industry 2.2. The major players ... 2.3. The regulatory framework.. 2.3.1 2.3.2 Current regulations.. Projects underway ISSUES IN THE MUTUAL FUNDS SECTOR 3.1. Governance 3.1.1 Plurality of functions 3.1.2 Forming an independent review committee 3.2. Information exchange. 3.2.1 Limits on disclosure of information by auditing firms.. 3.2.2 Restrictions on informing the law enforcement community 3.3. Investor compensation. 3.3.1 Investor compensation in the United States 3.3.2 Investor compensation in Canada 3.3.3 Recent developments in investor compensation: civil remedies on secondary markets 3.3.4 The financial services compensation fund (Québec only) 3.3.5 The limits of Québec's compensation mechanisms... 3.4. Penalties 3.5. Other issues 4. CONCLUSION. APPENDIX I.......... APPENDIX II 1 3 4 5 5 34556 9 9 10 13 13 14 15 15 16 17 18 18 19 20 21 22 23 ii Consultation paper#8Empty#91. INTRODUCTION The Public Finance Committee is one of 11 permanent parliamentary committees of the Québec National Assembly. It has 12 members representing all political parties in the National Assembly. The Committee deals with matters relating to finance, budgets, public accounts, government administration, public service as well as supplies and services. The Committee has undertaken this study of investor protection by virtue of its power of initiative. It was in September 2003 that it first expressed its interest in the topic of investor protection in Québec. Recent events in Québec and elsewhere in the world had pointed to the importance of this issue, which involves many players, including the Committee members in their role as legislators and citizen representatives. The Committee elected to focus on the mutual funds sector in particular because of its large size ($83 billion in Québec for 2005) and recent problems in the industry. In February 2006, the MNAS serving on the Committee began preliminary discussions during their work sessions to probe certain facets of the issues. The Committee then heard from The Investment Dealers Association of Canada; the Canadian Association of Personal Insurance Companies; Autorité des marchés financiers; Caisse de dépôt et placement du Québec; the Conseil des fonds d'investissement du Québec; Mr. Jean-François Guimond, a professor at Université Laval's Department of Finance and Insurance; Mr. Stephen Jarislowsky of Jarislowsky, Fraser Itée; Mr. Michel Marcoux, a columnist at the Le Devoir newspaper; and Option Consommateurs. With this consultation paper, the Committee begins the principal phase of its work, which is to hold public hearings. This paper does not claim to be exhaustive. Rather, it aims to be a tool for encouraging discussions on a matter that affects a not inconsiderable number of citizens. The paper is therefore not intended only for experts and specialized groups, but also for citizens themselves as individual investors, since they are the main ones concerned. The Committee will select individuals and organizations to invite for hearings from among those who submit briefs. Consultation paper Page 1#10The Committee does not take a position on the issues raised in this paper. Once the general hearings are completed, the legislators will finish their deliberations and will be able to formulate their recommendations in a report to the National Assembly. The Committee's goal with these hearings is to give voice to the men and women of Québec who feel they have a stake in these issues. They are invited to submit a brief to the Committee. For those who do not wish to present a brief, you may share your comments with the Committee by taking part in an online consultation at the following Internet address: http://www.assnat.qc.ca/fra/37legislature2/commissions/Cfp/index.shtml Sam Hamad MNA for Louis-Hébert and Chair of the Public Finance Committee Rosaire Bertrand MNA for Charlevoix and Vice Chair of the Public Finance Committee Consultation paper Page 2#112. OVERVIEW OF THE MUTUAL FUND INDUSTRY 2.1. A big industry Mutual funds constitute a very large and fast-growing financial products sector. In Québec, the total value of the assets under management was $83.3 billion for the third quarter of 2005, or 15% of all Canadian mutual fund portfolios. Mutual fund assets grew on average by 16.6% a year in Québec and by 14.6% a year in Canada¹ from 1995 to 2004. Québec investors have traditionally displayed a more conservative attitude in their investment choices. Although these investors are increasingly active in the mutual fund market, the types of financial assets held (figures 1 and 2) still show a preference for mutual funds with a lower risk profile. Figure 1 % breakdown among mutual fund types in Québec, 3rd quarter 2005 Mortgage 1.8% Money Market Other 3.3% 11.3% Balanced 20.8% Equity 45.9% Rixed Income & Bond 16.9% Source: Institut de la statistique du Québec 1 Figure 2 % breakdown among mutual fund types in Canada, 3rd quarter 2005 Money Mortgage 0.8% Market Other 8.5% 0.4% Balanced 21.3% Equity 57.0% Fixed Income & Bond 12.0% Source: Investment Funds Institute of Canada (IFIC) INSTITUT DE LA STATISTIQUE DU QUÉBEC, Évolution des fonds communs de placement au Québec, February 2006 [online] [http://www.stat.gouv.qc.ca/bul/finances/pdf/hors_serie_fonds_communs.pdf] Consultation paper Page 3#12As with other areas of the financial products sector, industry concentration is relatively high. In December 2005, the ten biggest firms offering mutual funds in Canada managed nearly 78% of the total assets held in Canadian funds². There are 210 mutual funds grouped into 24 families in Québec. The province has 411 "brokerage advisory firms" employing over 28,000 sales reps who are registered in the securities field and authorized to work in this sector. About 21,000 of these specialize exclusively in mutual funds³. A number of factors explain the growing popularity of mutual funds, including the aging population, the increased number of well-to-do investors, and the greater number of actual funds available. 2.2. The major players The mutual funds industry is mainly composed of promoters (managers) and distributors. Banks and credit unions play the roles of both promoter and distributor. Consumers can buy mutual fund shares from financial advisors, mutual fund sales reps, lending institutions, financial planners, and securities brokers. Mutual funds involve several parties at different operational levels. Below is a list of the main players. " ◉ ☐ The fiduciary holds the securities that belong to the fund on behalf of the shareholders. The management company (or manager) often acts as a funds promoter. It sets up one or several funds, administers them, and markets them. The custodian is the fiduciary bank or company appointed by the management company to safeguard the securities held in the fund. The investment advisor is the professional financial manager appointed by the management company to direct the investments. The company often takes on the investment advisory role itself, in which case it makes all of the investment decisions, constantly monitors economic conditions, and modifies the investment allocation accordingly. The principal distributor coordinates the sale of the mutual fund shares to investors, either directly or through the network of registered securities dealers. 2 3 INVESTMENT FUNDS INSTITUTE OF CANADA, Table showing the relative position of members, December 2005. [online] [https://statistics/ificmembers.ca/English/reports/2005/12/public/relativepos.xls] (Consulted on March 1, 2006) AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 29 Consultation paper Page 4#13The auditor is an independent accounting firm retained by the management company to audit the fund's financial statements once a year. 2.3. The regulatory framework 2.3.1 Current regulations Mutual fund regulation in Canada is highly harmonized among the provinces and territories. In order to allow the issuers to conduct business while at the same time complying with regulations, the Canadian Securities Administrators (CSA) are responsible for ensuring that document filing requirements have been met under the Continuous Disclosure Review Programme (CDRP). The CSA also reviews requests for exemptions from applicable regulations and renews annual short-form prospectus visas. Additionally, since mutual funds can be distributed in more than one province, they must comply with the pertinent legislation of each of these provinces. The fund manager's headquarters address determines which securities administrator has principal authority over the fund. Mutual fund regulation in Québec is comparable to that which prevails elsewhere in Canada. It falls under the aegis of the province's Autorité des marchés financiers (AMF), which regulates the entire financial services sector. The Autorité enforces two major laws governing the mutual fund sector: ☐ ■ The Québec Securities Act, which provides for two regulatory bodies covering the issuers and distributors working in the securities markets. Québec's Act respecting the distribution of financial products and services, which more specifically concerns the work of sales reps involved in the distribution of financial products and services such as mutual funds. Québec's Act respecting the Autorité des marchés financiers stipulates that the Autorité can delegate some of its functions and powers to outside bodies. Such bodies are referred to as self-regulating bodies (SRB). The self-regulation model draws on the industry's expertise Consultation paper Page 5#14and practical experience while freeing the government from assuming the bulk of the costs for these activities4. Two principal SRBS operate in the mutual fund industry. The Investment Dealers Association of Canada (IDA) regulates the activities of its 190 members employing some 39,000 people. Its purpose is to protect investors while ensuring the market's integrity. In addition, it aims to foster fairness, competitiveness, and efficiency in the capital markets. Chambre de la sécurité financière (CSF) is responsible for the discipline, training, and ethics for its 28,000 members from the personal insurance and brokerage fields. A syndic with investigative and administrative powers is appointed to supervise these practices. The chart at the end of this chapter offers a simplified depiction of the mutual fund sector's legal and regulatory framework. 2.3.2 Projects underway There are a few noteworthy regulatory projects now being developed. IDA launched a task force in June 2005 charged with modernizing securities legislation in Canada 5. This task force intends to review five major issues: individual investor protection, obligations with respect to governance, access to capital and the prospectus requirement, the regulatory burden, and regulatory implementation. 4 5 Ultimately, whether oversight is exercised by the public or private sector, the cost is passed on to the consumer through higher fees. The model also poses the problem of potential conflicts of interest. The SRBs' mechanisms of checks and balances can minimize this problem. THE INVESTMENT DEALERS ASSOCIATION OF CANADA, IDA launches the Task Force to Modernize Securities Legislation in Canada, [Online] [http://www.ida.ca/Files/Media/Media Release/General/MRG200506270_en.pdf] (Consulted in February 2006) Consultation paper Page 6#15The CSA also formulated plans in 2004 to reform the registration procedures by reviewing all of the relevant legislative and regulatory provisions and examining the possibility of widening the registration requirement to include mutual fund managers. This obligation would allow the authorities to check the managers' backgrounds and to ensure that the company has sufficient resources to fulfill its obligations to investors and to reimburse them should these obligations not be met. Lastly, the CSA has proposed regulation 81-1076 aimed at improving the governance of investment funds by putting them under the control of an independent review committee (IRC). The committee would be composed of a minimum of three independent directors and would serve the investors' interests. It would ensure that the management company acts in the investors' interests, notably by avoiding conflicts of interest. The proposal also establishes the management company's obligations should conflicts of interest arise. The proposed regulation 81-107 is expected to enter into force in Québec and the rest of Canada sometime in 2006. 6 The proposed regulation 81-107 was published for commentary on two occasions, namely in January 2004 and in May 2005. The CSAs' previous proposition was 81-404, in March 2002. [http://www.cvmq.com/Upload/fichier_pdf/norme/81-107fr_cons.pdf]. Available in French only. Consultation paper Page 7#16SIMPLIFIED CHART OF THE MUTUAL FUND INDUSTRY'S LEGAL FRAMEWORK AUTORITÉ DES MARCHÉS FINANCIERS Act respecting the Autorité des marchés financiers Québec Securities Act Mutual fund supervision, notably concerning reporting and securities dealers Act respecting the distribution of financial products and services Supervision of the work of sales reps involved with financial products distribution, particularly mutual funds Regulations and other enactments Securities regulations + Various regulations, instructions, and notices concerning mutual fund companies Regulations and other enactments Various regulations and enactments covering sales rep certification, consumer information, the compensation fund, registration of sales reps and firms, and Chambre de la sécurité financière Self-regulating body Investment Dealers Association of Canada (IDA) Consultation paper Self-regulating body Chambre de la sécurité financière (CSF) Sales representatives Mutual funds Investors Page 8#173. ISSUES IN THE MUTUAL FUNDS SECTOR Below we will mainly cover the issues that the Committee has elected to broach with regard to mutual funds. However, the Committee is aware that any regulatory changes implemented to correct these weaknesses would have potential effects on other similar financial products. Thus, the Committee believes that should the regulatory framework governing mutual funds change, so should that aimed at the other investment products. These products should be subject to equivalent rules so that the regulation does not introduce distortions in the products offered or in consumers' choices. This way, investors can base their investment choices on comparable standards. 3.1. Governance 3.1.1 Plurality of functions In the mutual fund industry, individuals can act as fund managers, promoters, fiduciaries, and principal distributors through the entities that they control. The situation also arises in large institutions like banks and credit unions, which nonetheless have different management teams. Though not specific to Québec, plurality of functions seems to be practiced for reasons of efficiency here, both for economic and administrative purposes. Actually, the fact that mutual fund managers perform several duties, either directly or through other members of their groups, reduces operating costs and administrative delays. This is because managers are quite often qualified to manage the various operations of a mutual fund. However, a growing number of observers are advocating a strict separation of roles for those operating in the mutual fund sector owing to the potential risks of losses for investors. 7 8 According to Autorité des marchés financiers, nearly 85% of mutual fund managers in Ontario are also registered as financial advisors or are members of a group registered as such. The plurality of functions carries certain risks according to Autorité des marchés financiers. These include the inability to compute the net asset value correctly or at an opportune time, the inability to draw up financial statements and reports correctly or at an opportune time, and conflicts of interest between the manager and investors, such as for management fees for example. Consultation paper Page 9#18Certain experts say that, although the separation of roles is needed to improve governance, it is not a panacea. They underscore the fact that fiduciary power risks being "illusory" if the manager or the entity the manager is supposed to supervise continues to have the power to terminate the fiduciary's contract. These experts insist on the need to provide the fiduciary with the proper tools to perform its job. Some industry players take the same view when they call for enhancing the fiduciary's role as exercising ultimate control over the fund. In the event the fiduciary cannot carry out all of the functions needed to administer the fund, the other parties should be independent of the fiduciary. Other industry representatives assert, however, that the separation of roles could adversely affect the viability of some small firms owing to the additional costs they would incur that would eventually be passed on to investors. Other spokespersons even invoke the possibility that this separation constitutes a barrier to entry for the smallest companies in addition to affecting the biggest institutions where the problem of confusion of roles does not arise. That is why, these advocates assert, one would have to accurately assess the "real" impact of such a measure on investor protection in the mutual fund sector. The Autorité shares this viewpoint. Indeed, it recommends that a suitable assessment be made of the risks that would be likely to result in investor losses in order to prescribe the appropriate regulation. It also raises the issue of harmonization with the rest of Canada, which merits particular attention. Questions 1. Would you favor the separation of roles in the mutual fund industry? 2. In your opinion, what are the benefits and drawbacks of such a separation? 3.1.2 Forming an independent review committee There are several situations in today's mutual fund industry, like in the investment fund industry generally, where the management company's interests could come into conflict with those of investors. Autorité des marchés financiers identifies two types of conflicts: ➡ Structural conflicts, which arise when the management company offers to acquire the securities of an issuer with which it has ties. Whether it conducts the trades on Consultation paper Page 10#19D this issuer's securities or transactions between funds (involving securities between the funds belonging to the same family), it risks furthering its own interests at the expense of those of its shareholders. This is why these transactions are forbidden or restricted under securities regulations, both in Québec and elsewhere in Canada. Commercial or operational conflicts of interest, which are those that generally arise when a management company operates a mutual fund. Examples include when the management company uses the services of its affiliated companies to operate the fund, or in allocating the expenses incurred in this operation, or during the allocation of securities among the mutual funds in one family. Although they could adversely affect investors, these conflicts of interest are not covered by any specific securities regulation. Regulation 81-107 is now being drafted to deal with these types of conflicts of interest. It provides for an independent review committee (IRC) composed of at least three directors to be set up by all of the issuers covered by the regulation. While regulation 81-107 sets forth the management company's obligations should case of conflicts of interest arise and also defines the requirements pertaining to the IRC's organization and working, subsequent modifications require that the IRC report to investors and that its existence be disclosed in the short-form prospectus. Although it "aims to impose a minimum standard of governance for all mutual funds," there are various opinions over forming an IRC. Indeed, certain industry advocates fear that, because of the cost it would incur and the difficulties in finding independent directors (owing to the size of the Québec market), the IRC constitutes a barrier to market entry for small firms. Such a consequence could stifle competition in a market dominated by the big institutions that already possess comparable structures. These industry representatives believe that investors will indeed be better protected by the IRCS, but not necessarily "better served." On the other hand, some institutional investors favor forming IRCs because they would provide better protection for investors by supervising transactions between affiliated entities. These advocates even recommend expanding the IRC's roles to improve this 9 AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 29 Consultation paper Page 11#20protection. This proposal is supported by Mouvement d'éducation et de défense des actionnaires (MEDAC), which recommends strengthening mutual fund governance by requiring that funds have an independent board of directors whose powers would exceed, by definition, those of an IRC. This obligation would also apply to financial services firms. Such a board of directors should also have a majority of independent members 10. It is nonetheless important to note some experts believe that, while reducing conflicts of interest, setting up an independent board of directors would not be sufficient to ensure that managers do not "deviate" from their official duties. Moreover, these experts point to certain difficulties, including who will sit on the board of directors and how we can know the board will perform the same, regardless in which fund you invest. Questions 3. Would setting up an IRC better protect Québec's investors? 4. Can this mechanism adversely affect small firms that want to do business in the Québec mutual funds market and, consequently, work to the advantage of the big institutions? 10 Since 1940, US law has stipulated that a board of directors be responsible for a mutual fund's management. Robert COURNOYER, Fonds communs et gouvernance, une histoire à suivre..., APÉIQ newsletter, Vol. VIII, No. 1, Spring 2004, pp. 7-8 Consultation paper Page 12#213.2. Information exchange It is said that financial markets authorities are only as effective as their ability to access reliable information and take action in case of a problem. Under its incorporating Act and the particular laws that apply in this area, Autorité des marchés financiers is empowered to supervise the entire mutual fund sector in Québec. It has inspection and investigative powers to check that practices are in compliance and enforcement powers to ensure that investors are protected. In addition to delegating some of its powers to self-regulating bodies, the Autorité also works closely with several other bodies that play specific roles in financial market supervision, investigation, and enforcement. Some observers state that this collaboration is quite limited in practice by current legislation in Québec relating to the exchange and disclosure of information. Here the Autorité faces two types of problems: 1) that of exchanging information with auditing firms and 2) that of taking joint action with the law enforcement community. 3.2.1 Limits on disclosure of information by auditing firms Mutual funds that are reporting issuers are required to file with the Autorité annual financial statements that have been audited by an outside auditor. Thus, the auditor plays an important role in ensuring that the fund's practices are in compliance and that there is no other situation that could create losses for investors. Under current regulation in Québec, these situations may not be notified to the regulatory bodies ¹¹. According to the Autorité, "....even if the auditor notes shortcomings in a reporting issuer's internal controls, it can implement compensating procedures that enable it to submit an unqualified auditor's report. This fact, though worrisome, will neither be disclosed to the public nor to the Autorité¹²." The exchange of information is also limited between 1) the bodies responsible for supervising the outside audit, namely Ordre des comptables agréés du Québec (OCAQ) and the Canadian Public Accountability Board (CPAB) 13, and 2) the Autorité and both of these two organizations. For the OCAQ, Professional Code confidentiality rules are what forbid both the Corporation and its members from conveying certain information obtained from 11 12 133 13 This mainly refers to articles of the Québec Civil Code, the Professional Code and the Canadian Charter of Rights and Freedoms. AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 47 The CPAB was formed in April 2003 at the initiative of the securities regulatory authorities and the Canadian Institute of Chartered Accountants. It is a non-profit organization, independent of the profession that aims to protect the Canadian public by inspecting auditing firms for which it has supervisory responsibility. Consultation paper Page 13#22investigations or inspections to the Autorité, the CPAB, or any other body. In the case of the CPAB, information exchanges between the Autorité and the CPAB are not allowed under current laws even though the Board has investigative, inspection, and even punitive powers over the registered auditors. 3.2.2 Restrictions on informing the law enforcement community Section 297.1 of the Securities Act was amended recently to allow the Autorité to provide information to Québec police authorities of a personal nature concerning individuals targeted by its investigations of the securities industry. To this end, the Autorité investigators work closely with the Special Investigations Unit (SIU) 14 which deals with tax- related financial crime. However, there are still problems with how the law enforcement community could use the information gathered by the Autorité thanks to its investigative powers. Indeed, some court rulings do not allow information to be admitted as evidence that was forwarded by bodies with binding authority (like the Autorité) to ones without the same powers (like police departments). 14. The Special Investigation Unit (SIU) was created in 2004. It is composed of investigators from Autorité des marchés financiers, Sureté du Québec (Tax Crimes Investigation Unit) and Ministère du Revenu. Consultation paper Page 14#23The Autorité faces the same type of legal difficulties in its collaboration with the Integrated Market Enforcement Team (IMET) 15. However, it plans to exchange resources with the IMET in FY 2006-2007 "to increase collaboration and ensure a better understanding of how it operates 16." Questions 5. Does the exchange of information and better cooperation with the law enforcement community help to improve investor protection? 6. Is it necessary to amend current laws to improve the information exchange among regulatory bodies and auditing firms? 7. Should there be legislative amendments so that the police departments can effectively use the evidence gathered by regulatory bodies, particularly with respect to its admissibility before the courts? 3.3. Investor compensation 3.3.1 Investor compensation in the United States There is no fund to compensate investors against securities fraud in the United States, although it is estimated to range from USD $10-40 billion a year ¹7. However, the Securities Investor Protection Corporation (SIPC) has offered coverage against insolvency since 1970 that protects investors in the event a full service brokerage firm goes bankrupt. Brokerage firms that specialize in mutual fund distribution are excluded from this coverage. Article 308 of the Sarbanes-Oxley Act provides for compensating the victims of securities law violations through the Federal Account for Investor Restitution, or FAIR Fund. This fund can refund to investors the money recovered from civil penalties and disgorgement. The court decides whether to impose an administrative penalty and the amount demanded. For example, insider trading is subject to a maximum fine of three times the illegal gain. 15 16 The Canadian government created the IMET in the wake of the Enron and Worldcom accounting scandals. It is composed of investigators and other specialists, including lawyers, accountants, forensic accountants, and IT professionals. The IMET's mission is to prevent and detect financial frauds perpetrated by companies whose capitalization is large enough to disturb investors' confidence in the financial markets. AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 45 17 According to the Federal Trade Commission (FTC) and the Federal Bureau of Investigation (FBI) Consultation paper Page 15#2419 18 18 Moreover, the Sarbanes-Oxley Act modified the Bankruptcy Act to prevent debt forgiveness through disgorgement during a bankruptcy. The Securities and Exchange Commission (SEC) also recommends certain modifications to improve victim compensation 18. 3.3.2 Investor compensation in Canada In Canada, the investor protection measures cover insolvency cases as well as certain breaches of the securities laws. Protection against deposit-taking institution insolvency is the responsibility of the Canada Deposit Insurance Corporation (CDIC), which insures bank deposits for up to $100,000 per person, and certain provincial protection funds, including Fonds de l'assurance-dépôts du Québec (FADQ), which offer the same coverage in a credit union or a trust company. This program covers bankruptcy cases. In the securities sector, the IDA administers the Canadian Investor Protection Fund (CIPF). This fund protects investors should a securities broker go bankrupt. It covers losses up to one million dollars per qualified account. It should be noted that mutual funds offered by deposit-taking institutions are also covered in bankruptcy cases when they are sold through a subsidiary registered with the CIPF. Since July 1, 2005, the Mutual Fund Dealers Association of Canada (MFDA) has protected investors in the event a mutual fund dealer goes bankrupt in any province other than Québec 19. Details of the recommendation can be found at the website below: [http://www.sec.gov/news/studies/sox308creport.pdf]. Discussions are underway with this body to facilitate securing the protections currently offered by Autorité des marchés financiers and those provided by the MFDA. This is to prevent firms and mutual fund sales reps from overcharging, among other things. Consultation paper Page 16#25In addition, other types of protection are available when securities laws are breached in Québec and in other provinces and territories, This entails actions that are more complex than the compensation mechanisms, and which often require the intervention of securities authorities. Inspired in large part by the prerogatives offered under Article 308 of the Sarbanes-Oxley Act in the United States, these remedies enable courts to order the person or company in violation to compensate an injured person or company. Lastly, most securities brokerage firms take out loss insurance to compensate clients who could be victims of fraudulent practices at the hand of financial advisors. 3.3.3 Recent developments in investor compensation: civil remedies on secondary markets Ontario recently added provisions to its legislation 20 allowing investors to claim damages, mainly for being given false, misleading or spotty information. Investors can now sue the companies and other key parties (directors, officers, and experts) when the information is false or misleading or when the required information is not disclosed in the companies' published documents. British Columbia has also inserted a civil liability regime for the secondary market in its new securities legislation, which has not yet entered into force. Other provinces (Alberta, Saskatchewan, Manitoba, New Brunswick, and Nova Scotia) are expected to submit bills to their respective legislatures that draw heavily from the new provisions adopted in Ontario. In Québec, Autorité des marchés financiers is now analyzing the Ontario law to ascertain the feasibility of importing this reform to Québec's secondary markets. 20 Namely, the new Part XXIII.1 of Ontario's Securities Act entitled Civil Liability for Secondary Market Disclosure (sections 138.1 to 138.14). Consultation paper Page 17#263.3.4 The financial services compensation fund (Québec only) Autorité des marchés financiers manages a financial services compensation fund called the Fonds d'indemnisation des services financiers (FISF). This fund, the only one in North America, compensates investors up to a limit of $200,000 in the event of fraud or embezzlement committed by a registered intermediary doing business in the following sectors: mutual funds, personal insurance, group insurance, loss insurance, claims settlement, financial planning, scholarship brokerage, and investment contract brokerage. The distributors fund the FISF in keeping with the risks this business incurs. It is the Autorité that decides whether or not the investor receives compensation after filing an application in the year of becoming aware of the fraud, accompanied by supporting documentation. Québec also provides other types of legal remedies for investors. There are general law remedies available under the Québec Civil Code and specific remedies stipulated under the Securities Act. Other statutory remedies may also be available and these give rise to class action remedies on occasion. 3.3.5 The limits of Québec's compensation mechanisms Despite the existence of several types of coverage in Québec, mutual fund holders may sometimes find they have no protection after losing their assets. These situations are due to the following provisions, among others: ➡ The FISF does not cover fraud that was committed outside of the covered disciplines. The FISF does not cover fraud committed by a person who is not acting in the capacity of a sales rep or retail firm, e.g. a mutual fund manager. The FISF does not cover bankruptcy cases. D Fraud situations are not covered by the CIPF. ➡>> The loss insurance offered by brokerage firms does not cover fraud committed by the firms themselves. Consultation paper Page 18#27To remedy such situations, there are proposals to expand the protection provided by the FISF. Others fear, however, that such an extension would incur additional costs that could be passed on to investors. The Autorité deems, for its part, "...that it is premature to expand compensation coverage to other industry operators such as managers. Indeed, any protection and compensation scheme must be based on representative experience. The situation over the past five, or even ten years must be thoroughly analyzed before the need for a supplementary compensation plan can be established. 21″ It recommends instead first tightening the regulatory requirements governing those operating in the mutual fund sector. Some experts, it should be noted, claim to be totally opposed to having compensation mechanisms cover the risk of fraud. Not only is it difficult to establish suitable rates for such coverage, they say, but it would encourage managers to deliberately take greater risks. Questions 8. Do you think that mutual fund investors have sufficient coverage under the various mechanisms in place in Québec and Canada? 9. Is it necessary to expand the FISF's coverage? 10. Is it desirable to set up a civil remedy regime on the secondary markets like the one adopted in Ontario? 3.4. Penalties Québec is one of the toughest provinces, along with Ontario and Alberta, in fighting white collar crime, particularly securities-related crime. The maximum sentences that may be imposed are five years in prison less one day and a fine of up to five million dollars. The Authorité may exact these penalties in cases of insider trading; predatory, abusive or fraudulent practices; and for any other financial crime covered by Section 208.1 of the Securities Act. Despite these provisions, some observers claim that the sentences imposed in Québec are not severe enough and don't have the desired deterrent effect. MEDAC, for one, takes this point of view. It proposes imposing a minimum sentence of 20 years in prison and the requirement to pay back the fraudulent gains in full. Other industry players 21 AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 57 Consultation paper Page 19#28recommend strengthening penalties and introducing a new third party liability that would apply to lawyers, accountants, brokers, bankers and others who take part in fraudulent deals. They also suggest modifying the Québec Companies Act to include sanctions against company executives and officers, particularly when they abscond with company funds. Lastly, Option Consommateurs favors a sharp increase in penal sanctions together with civil liability measures that would enable victims to recover the illegally gained funds. However, in the eyes of Autorité des marchés financiers and various other observers, the issue is rather a matter of the actual sentences applied compared with what is theoretically possible. At present, the maximum penalties are hypothetical since the courts impose them only in exceptional cases. Thus, the Autorité states "... in the majority of regular cases that do not make front page news like the big scandals, the minimum penalty is applied since prosecutors cannot invoke particular circumstances to justify a harsher penalty22." This is why it is advocating increasing the minimal penalties, which would be more effective that raising the maximum ones. In order to obtain the desired deterrent effect, it recommends strict enforcement of the current laws relating to the penalties and fines for white collar crime. More generally, the Authorité recommends sensitizing all of the parties concerned to the serious nature of white collar crime so as to obtain changes in the jurisprudence. Questions 11. Are the penalties imposed for white collar crime severe enough? 12. What measures do you favor to obtain a better deterrent effect? 3.5. Other issues Several other issues have been raised in the mutual fund sector. Some people have highlighted the problem of "exit fees" which oblige investors to pay big penalties if they wish to withdraw their investments from a fund whose investment objectives may change owing to a reorientation of the fund family or a change in manager. Other commentary has centered on the role of Autorité des marchés financiers. This body's mission has several facets that range from financial markets supervision to consumer assistance and 22 AUTORITÉ DES MARCHÉS FINANCIERS, Mémoire préparé dans le cadre des travaux préliminaires (brief drafted during the preliminary work), p. 43 Consultation paper Page 20#29compensation. As for mutual funds, some have questioned the Autorité's conduct, particularly its ability to take effective action in this type of case. Finally, some industry operators have noted the lack of sufficient resources allotted to education on buying and using financial products and services. These resources are currently limited to the fund that falls under the aegis of the Autorité, and only cover investor education and governance promotion. Questions 13. Is it a good idea to abolish mutual fund exit fees in certain cases? 14. Do you think Autorité des marchés financiers has sufficient resources to carry out its mission? 15. Should the Autorité's powers be reviewed? 16. What would you propose to improve investor knowledge in choosing investments and the risks incurred? 4. CONCLUSION With this consultation paper, the Public Finance Committee wishes to open the debate on the issue of investor protection in Québec's mutual fund sector. The Committee invites you to voice your opinion on one or all of the topics covered. This document does not claim to be exhaustive, so you may bring up another topic that you deem pertinent. You may also express your opinion by completing the online questionnaire. The Committee thanks you for your participation and invites you to follow the progress of its deliberations. Consultation paper Page 21#30Empty#31APPENDIX I AMF CDIC Canada Deposit Insurance Corporation CDRP List of abbreviations and acronyms Autorité des marchés financiers Continuous Disclosure Review Programme CIPF Canadian Investor Protection Fund CPAB Canadian Public Accountability Board CSA CSF FADQ Fonds de l'assurance-dépôts du Québec FAIR FISF Fonds d'indemnisation des services financiers IDA IMET IRC MEDAC MFDA OCAQ SEC SIPC SIU SRB Canadian Securities Administrators Chambre de la sécurité financière Federal Account for Investor Restitution Investment Dealers Association of Canada Integrated Market Enforcement Team independent review committee Mouvement d'éducation et de défense des actionnaires Mutual Fund Dealers Association of Canada Ordre des comptables agréés du Québec Securities and Exchange Commission Securities Investor Protection Corporation Special Investigations Unit Self-regulating body Consultation paper Page 22#32Empty#33APPENDIX II GLOSSARY Assets: What a firm or individual owns. Balanced fund: A mutual fund which has an investment policy of "balancing" its portfolio generally by including bonds and shares in varying proportions influenced by the fund's investment outlook. Board of directors: A committee elected by the shareholders of a company, empowered to act on their behalf in the management of company affairs. Directors are normally elected each year at the annual meeting. Bond fund: A mutual fund whose portfolio consists primarily of bonds. Broker: An agent who handles the public's orders to buy and sell securities, commodities, or other property. A commission is generally charged for this service. Custodian: A financial institution, usually a bank or trust company that holds a mutual fund's securities and cash in safekeeping. Debenture: A bond unsecured by any pledge of property. It is supported by the general credit of the issuing corporation. Distributions: Payments to investors by a mutual fund from income or from profit realized from sales of securities. Diversification: The investment in a number of different securities. This reduces the risks inherent in investing. Diversification may be among types of securities, companies, industries, or geographic locations. Dividend fund: A mutual fund that invests in common shares of senior Canadian corporations with a history of regular dividend payments at above average rates, as well as preferred shares. Equity fund: A mutual fund whose portfolio consists primarily of common stocks. Fiduciary: An individual or institution occupying a position of trust, i.e., an executor, administrator, or trustee. Fixed income investments: Investments that generate a fixed amount of income that does not vary over the life of the investment. Guaranteed investment certificates: A deposit instrument paying a predetermined rate of interest for a specified term; available from banks, trust companies, and other financial institutions. Consultation paper Page 23#34Income funds: Mutual funds that invest primarily in fixed-income securities such as bonds, mortgages, and preferred shares. Their primary objective is to produce income for investors, while preserving capital. Investment adviser: Investment counsel to a mutual fund. Also may be the manager of a mutual fund. Investment company: A corporation or trust whose primary purpose is to invest the funds of its shareholders. Liabilities: All debts or amounts owing by a company in the form of accounts payable, loans, mortgages, and long-term debts. Load: Commissions charged to holders of mutual fund units. Management company: The entity within a mutual fund complex responsible for the investment of the fund's portfolio and/or the administration of the fund. It is compensated on a percentage of the fund's total assets. Management fee: The sum paid to the investment company's adviser or manager for supervising its portfolio and administering its operations. Money market fund: A type of mutual fund that invests primarily in treasury bills and other low-risk, short-term investments. Mortgage fund: A mutual fund that invests in mortgages. Portfolios of mortgage funds usually consist of first mortgages on Canadian residential property, although some funds also invest in commercial mortgages. Mutual fund: An investment entity that pools shareholder or unitholder funds and invests in various securities. The units or shares are redeemable by the fund on demand by the investor. The value of the underlying assets of the fund influences the current price of units. Open-end fund: An open-end mutual fund continuously issues and redeems units, so the number of units outstanding varies from day to day. Most mutual funds are open-ended. Portfolio: All the securities which an investment company or an individual investor owns. Prospectus: The document by which a corporation or other legal entity offers a new issue of securities to the public. Real estate fund: A mutual fund that invests primarily in residential and/or commercial real estate to produce income and capital gains for its unitholders. Real estate investment trust: A closed-end investment company that specializes in real estate or mortgage investments. Risk: The possibility of loss; the uncertainty of future returns. Consultation paper Page 24#35Shares: A document signifying part ownership in a company. The terms "share" and "stock" are often used interchangeably. Securities Act: Provincial legislation regulating the underwriting, distribution, and sale of securities. Secondary market: Everyday trading by investors in the shares of a public company- trading that is not part of a sale of shares to the public described in a formal disclosure document such as a prospectus. Simplified prospectus: An abbreviated and simplified prospectus distributed by mutual funds to purchasers and potential purchasers of units or shares (see prospectus). Yield: Annual rate of return received on investments, usually expressed as a percentage of the market price of the security. Source: Investment Funds Institute of Canada (IFIC) Consultation paper Page 25#36Empty