On January 28, 2013, the Office of the Superintendent of Financial Institutions Canada ("OSFI") released the final version of its revised Guideline on Corporate Governance (the "Revised Guideline"). The Revised Guideline is the result of a consultation process that began when draft revisions (the "Draft Guideline") to the 2003 Guideline on Corporate Governance were issued for public consultation from August 7, 2012 to September 14, 2012. The Revised Guideline sets out OSFI's expectations for corporate governance at all federally regulated financial institutions ("FRFIs"), and applies to all FRFIs except the branch operations of foreign banks and foreign insurance companies.
It is OSFI's view that strong corporate governance is essential to the safety and soundness of Canada's financial institutions, and that the Revised Guideline will help boards and senior management to identify and manage risks being undertaken by their financial institutions. In addition to complying with the Revised Guideline, OSFI expects the boards and senior management of FRFIs to be proactive, to be aware of best practices related to corporate governance that are applicable to their institutions, and to adopt these best practices where appropriate.
OSFI also expects that FRFIs will conduct a self-assessment of compliance with the Revised Guideline and establish a plan to address any deficiencies. FRFIs are asked to advise their OSFI Relationship Manager in writing of the results of their self-assessment and the related action plans by May 1, 2013. Self-assessments are to be retained by FRFIs and made available to OSFI upon request. OSFI expects that all FRFIs will fully implement the Revised Guideline by January 31, 2014.
APPLICATION OF THE REVISED GUIDELINE TO BRANCHES
The Revised Guideline applies to all FRFIs other than foreign bank branches and foreign insurance company branches. As branches do not have boards of directors and OSFI instead looks to the Chief Agent or Principal Officer to oversee corporate governance matters, the provisions of the Revised Guideline are not directly applicable to branches. However, it is our understanding that OSFI regards many parts of the Revised Guideline (such as enterprise risk management) as being relevant to branches and that it will therefore be important for Chief Agents and Principal Officers of branches to be familiar with and have regard to the requirements of the Revised Guideline. While it is not at all clear how some of the provisions of the Revised Guideline (such as those relating to board independence) may be reflected in OSFI expectations with respect to the corporate governance of a branch, we can expect that others (such as those relating to internal controls) will have direct and clear application to a branch.
OVERALL CHANGES FROM THE DRAFT GUIDELINE
In the Revised Guideline, OSFI has more strongly emphasized that FRFIs should apply the corporate governance guidance having regard to their own specific circumstances, recognizing that individual FRFIs will have different corporate governance practices depending on their size, ownership structure, nature, scope and complexity of operations, corporate strategy and risk profile. The Revised Guideline acknowledges the need for flexibility in adopting the new corporate governance standards, and OSFI has added qualifications and softened certain of the more prescriptive wording and expectations that had appeared in the Draft Guideline.
THE ROLE OF THE BOARD
The Revised Guideline highlights and distinguishes the roles of the board and senior management. The board is responsible for providing stewardship, including direction-setting and general oversight of the management and operations of the entire FRFI, whereas senior management is accountable for implementing the board's decisions and for directing and overseeing the operations of the FRFI.
In Section III of the Revised Guideline, OSFI outlines the essential duties that boards must discharge, in addition to the roles and responsibilities outlined in federal legislation. The section also differentiates between matters to be approved by the board (i.e., the primary functions of the board) and matters to be reviewed and discussed by the board. The Revised Guideline notes that although the latter functions are the responsibility of senior management, the board has a critical role in providing high-level guidance to senior management with respect to these matters.
In respect of board effectiveness, the Revised Guideline sets out a number of recommendations, including regularly conducted self-assessments of the effectiveness of board and committee practices (occasionally with the assistance of independent external advisors) and reasonable representation of relevant financial industry and risk management expertise at the board and committee levels.
The Revised Guideline views demonstrable board independence to be the core of effective FRFI governance. Beyond the principle of separating the roles of Chair and CEO, which OSFI regards as critical, OSFI does not view any one board structure or process as guaranteeing independence. The Revised Guideline recommends that the board document and approve a director independence policy that takes into consideration the specific shareholder/ownership structure of the institution, and that factors in director tenure where appropriate.
OSFI expects FRFIs to establish oversight functions that are independent from operational management. The size and sophistication of the oversight functions may vary based on the nature, size and complexity of a FRFI and its inherent risks. The heads of the oversight functions should have sufficient stature and authority within the organization, be independent from operational management and have unfettered access and a direct reporting line to the board. The Revised Guideline requires that the board regularly assess the effectiveness of the FRFI's oversight functions and processes, and conduct a benchmarking analysis of those functions or their processes with the assistance of independent external advisors.
In Section IV of the Revised Guideline, OSFI sets out a number of recommendations with respect to risk governance, which OSFI views as a distinct and crucial element of corporate governance of FRFIs.
Risk Appetite Framework (RAF)
A FRFI should develop and implement a board-approved RAF that is enterprise-wide and tailored to its domestic and international business activities and operations. It should be well-understood throughout the organization, embedded within the FRFI culture and supported by all operational, financial and corporate policies, practices, and procedures of the FRFI. It should also set basic goals, benchmarks, parameters and limits as to the amount of risk a FRFI is willing to accept. Moreover, it should consider the material risks to the FRFI and be forward-looking and consistent with the FRFI's business model, overall philosophy, short-term and long-term strategic plan, capital plan, financial plan, business objectives and corresponding risk mitigation strategy. The RAF should provide boundaries on the ongoing operations of a FRFI with respect to asset class and liability choices, activities and participation in markets that are not consistent with the FRFI's stated risk appetite. The expectation reflected in the Draft Guideline that the board should periodically commission independent third party reviews to assess the effectiveness of the FRFI's risk management systems and practices has been deleted.
The Revised Guideline directs that, depending on the nature, size, complexity and risk profile of the FRFI, the board should establish a dedicated board risk committee to oversee risk management on an enterprise-wide basis. The committee members should be "non-executives" and an adequate number of members of the risk committee should have sufficient knowledge in the risk management of financial institutions. The committee should seek assurances from the chief risk officer (CRO) (or equivalent) that the oversight of the risk management activities of the FRFI is independent from operational management, adequately resourced, and has appropriate status and visibility throughout the organization. The risk committee should provide input to the approval of material changes to the FRFI's strategy and corresponding risk appetite. In 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.
Chief Risk Officer (CRO)
According to the Revised Guideline, each FRFI should have a senior officer who has responsibility for the oversight of all relevant risks across the FRFI (CRO or equivalent), sufficient stature and authority within the organization, and is independent from operational management. OSFI has confirmed that in small, less complex FRFIs, the CRO role can be held by another executive (i.e., one with dual roles). The CRO should have unfettered access and a direct reporting line to the board or risk committee and the CRO and the risk management function should be independent of the business lines or operational management, and should not be directly involved in revenue-generation or in the management and financial performance of any business line or product of the FRFI.
ROLE OF THE AUDIT COMMITTEE
Section V of the Revised Guideline sets out the role and responsibilities of the audit committee, including that the audit committee should be responsible for approving external audit fees and the scope and terms of the audit engagement, review and approve the FRFI's internal and external audit plans to ensure that they are appropriate and risk based and probe, question and hold regular in camera meetings with the external auditor, chief internal auditor and appointed actuary (for insurance companies) to understand all the relevant issues and resolution of such issues. The Revised Guideline includes an expectation that the audit committee will recommend to the shareholders the appointment, reappointment, removal and remuneration of the external auditors and annually report to the board on the effectiveness of the external auditor.
SUPERVISION OF FRFIs
OSFI will undertake a number of approaches, including discussions with the board, board committees, senior management, and oversight functions, as well as the review of board and board committee material, in order to assess the effectiveness of a FRFI's corporate governance processes, and will seek evidence that the processes exist, are operating effectively and that the board is able to fulfill its roles and responsibilities. An additional expectation is that FRFIs notify OSFI of any potential changes to the membership of the FRFI board and senior management, and any circumstances that may adversely affect the suitability of board members and senior management.
The Revised Guideline raises the bar for corporate governance by introducing a number of significant new regulatory expectations for financial institutions in Canada. Although OSFI has made an effort to incorporate flexibility into the Revised Guideline, there is a concern that the guidance is too heavily targeted towards large financial institutions, and that the new expectations will be onerous and burdensome for smaller institutions to implement. Moreover, according to industry feedback, the expectation that financial institutions will conduct occasional independent third party reviews may prove onerous, expensive and intrusive. The main challenge for many FRFIs will be in determining how to implement the expectations set out in the Revised Guideline given their own particular circumstances. For subsidiaries of foreign parents that may have limited Canadian operations and a minimum number of non-affiliated directors, it may be a real challenge to fully comply with the intent of the Revised Guideline.
The Revised Guideline may be perceived by some as creating another reason why it may be preferable for foreign financial institutions to operate in Canada as a branch rather than by incorporating a subsidiary. However, it is likely that OSFI already has heightened expectations with respect to branch corporate governance and will eventually develop similar guidance for branches, if only to avoid the perception of an unlevel regulatory playing field in Canada.
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