Yesterday, Canada's federal financial institutions
regulator, the Office
of the Superintendent of Financial Institutions
(OSFI), released the final version of its revised Corporate Governance
Guideline (the Revised Guideline). The Revised
Guideline sets forth OSFI's expectations for the corporate
governance of federally-regulated financial institutions (FRFIs).
Like the previous Guideline issued in 2003, it applies to all FRFIs
except foreign bank branches and foreign insurance company
branches.
Last August OSFI released an initial draft of the Revised
Guideline, which was open for comment until September 14, 2012. We
reviewed that initial draft in our August 2012
Financial Services Update. OSFI received
detailed and critical feedback on the initial draft from the
relevant industry associations and a large number of FRFIs, and a
consultation process on the initial draft continued through the
fall. In December, OSFI released a significantly revised draft only
to the industry associations and sought only very material comments
on the December draft. OSFI ultimately accepted some, but not all,
of the key comments received (the materials released with the
Revised Guideline include an Annex summarizing the key comments
received and OSFI's response). As a result, despite the
industry's efforts, the Revised Guideline will impose a number
of significant new burdens on many FRFIs. This Financial Services
Update reviews the key changes to the Revised Guideline from the
initial August draft and considers the key consequences of the
Revised Guideline for FRFIs and some of the practical
implementation considerations for FRFIs.
Overview of the Revised Guideline
As noted in our August Financial Services Update, the Revised Guideline is intended to:
- ensure that FRFIs have prudent corporate governance practices and procedures that contribute to their safety and soundness;
- promote industry best practices in corporate governance;
- be consistent with and complement:
- the respective FRFI statutes and related regulations; and
- OSFI's Supervisory Framework ( most recently revised in 2011) and Assessment Criteria; and
- address international standards as articulated by a number of international organizations.
To best meet those goals, the Revised Guideline focuses on (i)
enhancing the effectiveness of Boards by providing clarity on board
responsibilities and competencies; (ii) strengthening FRFIs'
risk governance by requiring the development of a "Risk
Appetite Framework" (RAF) to guide risk-taking activities; and
(iii) improving the overall internal control framework of FRFIs by
clarifying the roles of the Chief Risk Officer and audit
committee.
The key sections of the Revised Guideline, namely Section III, IV
and V, focus, respectively, on three fundamental components of
corporate governance for FRFIs:
- the role of the Board;
- risk governance; and
- the role of the audit committee.
As noted above, the Revised Guideline applies to all FRFIs other
than foreign bank branches and foreign insurance company branches.
Branches do not have boards of directors and, accordingly, the
specific provisions of the Revised Guideline do not apply directly
to branch operations. Instead, OSFI looks to the Chief Agent or
Principal Officer of a branch to oversee the management of the
branch, including corporate governance matters. Those individuals
are recognized as having overall responsibility for their
respective branches and, therefore, should be aware of the contents
of the Revised Guideline. The Chief Agent or Principal Officer of
branches should refer to OSFI Guidelines E-4A or E-4B, as
appropriate.
Key Changes from the Initial Draft Revised Guideline
Overall
- OSFI has more strongly and prominently emphasized that FRFIs
should apply the guidance having regard to their own circumstances
and that the Revised Guideline is not a
"one-size-fits-all" set of expectations. OSFI recognizes
that FRFIs may have different corporate governance practices
depending on their size; ownership structure; nature, scope and
complexity of operations; corporate strategy; and risk
profile.
- OSFI has softened certain of the more prescriptive wording and
added qualifications acknowledging the need for flexibility in
adopting the Revised Guideline. For example, various expectations
in the initial draft that Boards or institutions would undertake
certain actions have been softened and qualified as being
applicable "where appropriate". Similarly, the phrasing
of a number of very prescriptive expectations, such that the Board
shall ensure that certain actions happen, or
verify certain assurances, have been eliminated or toned
down.
- The description throughout of "independent oversight functions" (finance, compliance, internal audit, actuarial and risk management) has been changed to merely "oversight functions".
The Role of the Board
- The expectation that a Board approve, among other things, the
appointment, performance review, compensation and succession plans
with respect to the CEO and other members of senior management
(including the heads of oversight functions) has been softened in
respect of senior management and the heads of the oversight
functions to only requiring approval where
appropriate.
- However, the Board is now expected to approve the mandate,
resources (amount and type) and budgets for the oversight
functions. This very granular and operational level requirement for
approval of budgets for oversight functions was strongly objected
to by industry associations as not being within the appropriate
role of the Board, but has nonetheless survived to the final
version of the Revised Guideline.
- Portions of Annex B in the previous Guideline and the initial
draft relating to the corporate governance responsibilities of the
Boards of subsidiary financial institutions have been relocated
into the body of the Revised Guideline. However, helpful
flexibility that was previously contained in Annex B has been
deleted. In particular, the acknowledgement that "at the same
time, this does not suggest that Boards of subsidiary institutions
should replicate all corporate governance activities of parent
Boards or that parent Boards should assume responsibility for the
performance of specific duties of subsidiary Boards" has been
deleted.
- The expectation in the original draft that the Board should
periodically commission independent third party reviews of Board
effectiveness and practices has been toned down in response to
vigorous criticism from industry associations and other
commentators that such reviews would result in expensive and
unnecessary duplication of existing controls and present a number
of issues related to the availability of reviewers, the purposes of
the review, process considerations and privilege issues. The
expectation now more flexibly provides that Boards should
occasionally conduct a self-assessment with the assistance
of independent external advisors and that the scope and
frequency of such external input should be established by the
Board. Consequently, although the scope and timing of the
obtaining of such input is left to the Board's discretion, the
expectation remains that external reviews should occasionally be
conducted.
- The suggestion that directors should seek internal or external
education opportunities in order to fully understand the risks
undertaken by the FRFI has been supplemented to also include
understanding developments in corporate and risk governance
practices.
- The initial draft focused in part on Board
"independence", which in this context OSFI described as
being much broader than the notion of "non-affiliated" as
defined in the various FRFI statutes. OSFI referred instead to the
concept of independence as having been described and elaborated
upon in various international reports and documents (which in turn
had stressed the ability and inclination to provide objective,
impartial challenge to management). This led to a concern that
affiliated directors could not qualify as "independent"
under this broader test, as they could not be independent enough to
provide objective, impartial challenge to management on behalf of
all stakeholders. Conversely, certain non-affiliated directors
might not have qualified as sufficiently "independent" in
the broad sense. This could have posed major challenges for FRFIs
that are subsidiaries of foreign groups and/or are controlled by an
individual sole shareholder or related group of individual
shareholders, and was consequently strongly objected to during the
consultation process. The guidance in the Revised Guideline has now
been softened to clarify that the Board should merely be
independent from senior management and that the Board's
behavior and decision-making process be objective and
effective, taking into account the particular circumstances of the
FRFI. The Revised Guideline also carries forward from the initial
draft the expectation that the Board have a director independence
policy that takes into consideration the specific
shareholder/ownership structure of the FRFI and, where appropriate,
director tenure. OSFI's broader notion of
"independence" also now reflects "legal"
documents including "securities law".
- The expectation that individual Board members should be able to
meet regularly with management of business units and oversight
functions with or without other members of senior management
present has been strengthened to provide that such individual Board
members should meet regularly with such management
with and without other members of senior management
present.
- The expectation that senior management should ensure
that oversight functions have the resources and support to fulfill
their duties, are sufficiently independent of operational
management and have the capacity to offer objective opinions and
advice to the Board and senior management has now become a
responsibility of the CEO.
- The expectation that the heads of oversight functions should
have, for functional purposes, a direct reporting line to the Board
or the relevant Board committee (although still technically
reporting to the CEO) has been rephrased/clarified and relocated
from a footnote to an emphasized text box.
- As with the expectation that Boards engage independent third party reviews of governance processes, the similar expectation that Boards engage independent third party reviews of oversight functions and processes has similarly been softened to a requirement that the Board should occasionally conduct a benchmarking analysis of those functions and processes with the assistance of independent external advisors, with the scope and frequency of such external input being established by the Board.
Risk Governance
- The Board-approved RAF is now described as intended to be well
understood throughout the organization and supported by all
operational, financial and corporate policies and practices and
procedures. On its face these are very broad expectations that
could technically apply to every employee of the
organization and to all corporate policies and procedures,
rather than, for example, only the relevant employees
and/or the material policies and procedures.
- In response to industry feedback, the RAF has been
re-characterized as being intended to consider only the
material risks to the FRFI, and not, generically,
all types of risk.
- In Annex C, the recommended contents of the RAF have been
significantly expanded and clarified.
- The previously proposed expectation that the Board should also periodically commission independent third party reviews to assess the effectiveness of the FRFI's risk management systems and practices has been deleted altogether.
Risk Committee
- In response to critical industry feedback, the proposal in the
initial draft that the newly-required risk committee be comprised
of directors who are all "independent" in OSFI's
proposed broader sense has been softened to only being that the
members be "non-executives" of the FRFI. The notion of
"non-executives" is explained in a footnote to mean a
member of the Board "who does not have management
responsibilities within the firm". In another footnote, OSFI,
in a further concession, indicates that for small, less complex
FRFIs, in place of establishing a separate risk committee, the
Board should merely ensure that it has the collective skills, time
and information to provide effective oversight of risk management
on an enterprise-wide basis.
- The expectation in the initial draft that the risk committee should be responsible for approving, at least annually, the mandate, competencies and resources of the CRO, approving the CRO's performance reviews and overseeing succession planning for the CRO position and other key position within the risk management functions, has been deleted in the Revised Guideline, as this is now within the purview of the entire Board.
CROs
- The expectation that each FRFI have a designated CRO has been
softened to "a senior officer who has responsibility for the
oversight of all relevant risks across the firm (CRO or
equivalent)". As well, the expectation that, for functional
purposes, the CRO should have a direct reporting line to the Board
or risk committee has been clarified in the same fashion as
described above, and relocated from a footnote to an emphasized
text box. OSFI confirms in a footnote that in small, less complex
FRFIs, the CRO role can be held by another executive (i.e. the
executive has dual roles).
- The Revised Guideline newly states that the CRO's
compensation should not be linked to the performance (e.g. revenue
generation) of specific business lines of the FRFI.
- In a number of places, the expectation that the CRO and the
risk management function be independent of risk taking
activities and provide an independent view to the risk
committee has been softened/clarified to being objective
and providing an objective view.
- The expectation that the CRO should meet with the Board/risk committee on a regular basis without the CEO or other members of senior management present has been changed to with and without.
Role of the Audit Committee
- The previously proposed expectation that all audit committee
members be independent (which would have overruled the requirements
in the applicable FRFI statutes) has been deleted. This had been a
significant point of contention for industry commentators.
- The proposal in the initial draft that the chief internal
auditor, the chief financial officer and the appointed actuary
should have direct reporting lines to the audit committee has been
deleted and the expectation in the initial draft that the audit
committee should be responsible for approving external audit fees
and the scope of the audit engagement has been softened to the
expectation that the audit committee recommend to the shareholders
the appointment, reappointment, removal and remuneration of the
external auditors. The Revised Guideline also clarifies that the
audit committee should agree to the scope and terms of the audit
engagement and approve the audit engagement letter.
- An expectation has been added that the audit committee should
annually report to the Board on the effectiveness of the external
auditor.
- A proposed expectation that the audit committee should ensure that the financial statements fairly present the financial position, results of operations and the cash flows of the FRFI has been softened to requiring that the audit committee should probe, question and seek assurances from the external auditor that such financial statements fairly present such items.
Supervision of FRFIs
- FRFIs are newly expected to notify OSFI of any potential changes to the membership of the FRFI's Board and senior management, and any circumstances that may adversely affect the suitability of Board members and senior management. While an addition from the initial draft, this was significantly toned down from the December version.
Commentary
Key Consequences
As noted in our earlier Financial Services Update, the Revised
Guideline introduces a number of significant new expectations and
will raise the corporate governance bar for many financial
institutions in Canada. Even with the additional flexibility
incorporated into the final version, there remains significant
concern for smaller institutions that the Revised Guideline too
heavily reflects the large bank/large insurer context and will
prove significantly burdensome. Despite industry pushback, the
final version of the Revised Guideline includes a number of
provisions that supplement the relevant express requirements under
the applicable FRFI statutes, including the expectation for a new
risk committee and a CRO function. The expectation for occasional
independent third party reviews will also prove onerous and
expensive.
The challenge for all institutions will be determining how to
implement "appropriately" the expectations in their own
circumstances, whether they are a Canadian parent FRFI, a
subsidiary FRFI of a Canadian parent, a subsidiary FRFI of a
foreign parent, etc. While the additional flexibility is welcomed,
institutions are in some respects left with a double-edged sword
that ultimately offers little guidance on OSFI's expectations.
For some subsidiaries of foreign parents, often with limited
Canadian operations and a minimum number of non-affiliated
directors, the challenge will be how to best comply with the
expectations while making the best use of significant resources or
expertise available at the parent level.
Taking together, the additional expectations in the Revised
Guidelines may well incline new entrants to Canada to proceed by
way of a branch operation, rather than a subsidiary subject to the
much more onerous requirements of the Revised Guideline.
Practical Implementation Considerations
Commenters pleaded for a staged implementation of the Revised
Guideline, and OSFI eventually acquiesced. OSFI expects FRFIs to
conduct a self-assessment of compliance with the Revised Guideline
and to establish a plan to address any deficiencies. FRFIs should
advise their Relationship Manager in writing of the results of
their self-assessment and the related action plans by May 1, 2013.
The self-assessments are to be retained by the FRFI and made
available to OSFI upon request. Full implementation of the Revised
Guideline by FRFIs is expected by no later than January 31, 2014.
For directors of small and medium-sized FRFIs, OSFI will be
offering seminars on the Revised Guideline commencing in the
spring. FRFI Boards will be contacted directly with further
details.
Despite the breathing room, FRFIs will still consequently need to
promptly review and update all of their corporate governance
structures and processes to ensure "appropriate"
compliance with the Revised Guideline. In particular, they will
need to establish a risk committee and implement a CRO function, if
appropriate to their circumstances and not already implemented.
They will also need to consider their preferred approach on timing
and terms of engagement of third party advisors to provide
benchmarking assistance. Practically, the large Canadian banks and
life insurers and the larger property and casualty insurers are far
advanced in their compliance with the Revised Guideline. However,
for smaller life and P&C insurers, the impacts may be much more
significant.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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