Managers of investment funds will have to address concerns relating to the personal liability of IRC members if they hope to attract and retain the most qualified individuals for their IRC. In addition to understanding the scope of their potential liability for breach of the standard of care mandated by NI 81-107, IRC members will want to understand the indemnification and insurance coverage available to them. Another "necessary evil" will be the compensation of the IRC members. We expect that NI 81-107 will be released as a final rule later this summer – this Practice Bulletin assumes that the final version of NI 81-107 will be substantially the same as the last version published for comment.
Indemnities: Even the most diligent IRC member, who by any objective standard has appropriately discharged his or her standard of care in respect of a particular matter, will be concerned about being sued. Litigants typically name everyone remotely connected to a matter in dispute in the hopes of recovery from someone. Even an IRC member with an ironclad defence to a claim may well incur significant legal expenses defending the action. IRC members will be concerned about this exposure and may want the right to retain separate counsel if their defences differ from those of the manager and the other defendants.
This brings us to the issue of indemnities. An investment fund and a manager may indemnify an IRC member, a former IRC member and his or her legal representatives only where the following indemnification standard is met:
- the member acted honestly and in good faith, with a view to the best interests of the investment fund; and
- in the case of a criminal or administrative action or proceeding that is enforced by a monetary penalty, the member had reasonable grounds for believing that his or her conduct was lawful.
NI 81-107’s indemnification standard restricts the ability of a fund and the manager to indemnify an IRC member and is generally consistent with other regulatory provisions relating to investment funds such as section 4.4 of NI 81-102. It is worth noting, however, that clause (b) above introduces an additional element not found in the IRC’s standard of care in NI 81-107 nor in section 4.4 of NI 81-102 that may make it more difficult for an IRC member to claim a right to indemnification in certain instances. Applying NI 81-107’s indemnification standard to the indemnities from both an investment fund and its manager will have interesting ramifications, including in some cases the scaling back of existing indemnities. We are aware of indemnities given by fund managers or their parent companies to members of bodies similar to an IRC that are considerably broader than the indemnity a manager is permitted to give under NI 81-107. Imposing the NI 81-107 indemnification standard on the manager’s indemnity also has an important impact on insurance – leaving more of a gap to be covered by insurance that will likely drive up the cost of insurance.
Questions to consider are: Is it appropriate to provide the two indemnities? Can another entity in the manager’s corporate group provide an indemnity and, if so, must NI 81-107’s indemnification standard apply to limit its scope? What is the appropriate limit to each indemnity, if any? The CSA’s commentary notes that any indemnities given should be on "reasonable commercial terms" – What will this mean in practice? How do multiple indemnities dovetail so that someone knows who pays what and when? How does the provision of indemnities fit with insurance coverage? How would a claim under the indemnity given by a fund impact the fund’s NAV?
We expect indemnities will cover the full range of costs and expenses permitted by NI 81-107, including advances. Coverage for advances will be important to an IRC member as any type of civil, criminal or regulatory proceeding can extend over a long period of time and the IRC member will want to ensure his or her expenses are being met along the way. If in the end the IRC member is found not to have met NI 81-107’s indemnification standard he or she will be required to repay the advance.
NI 81-107 will give an IRC member the right to claim an indemnity from the fund and the manager even where the fund or the manager has not actually given one, if the IRC member has been found during a proceeding to have done everything he or she ought to have (including not omitting to have done something) and to have met NI 81-107’s indemnification standard. So even if an IRC member does not insist on an indemnity from the fund and/or manager upon becoming an IRC member the fund and manager are not necessarily out of the woods with respect to indemnifying that IRC member. Does this weigh in favour of providing a written indemnity from the outset to clearly establish its scope?
Insurance: An investment fund and its manager may purchase insurance to insulate IRC members from liability incurred in their capacity as IRC members. Insurance goes hand in hand with indemnification – among other things, insurers will want an IRC member to look first to the indemnities.
NI 81-107 does not impose a "standard of care" condition for insurance similar to NI 81-107’s indemnification standard leaving open to debate the appropriate limits of coverage. It is clear that a fund can pay the insurance premiums that are an obvious consequence of the fund providing insurance coverage to IRC members. While the rule itself does not address the extent of coverage or the quantum of premiums, the commentary indicates that the CSA expects coverage to be on "reasonable commercial terms". What will this mean in practice? Is a manager properly discharging its standard of care to offer a fund indemnity without also getting insurance? If both the manager and the fund provide insurance how will the two policies interact? Will IRC members insist upon their own direct coverage? Could the nature of the insurance obligations open up the manager to allegations of breach of its standard of care?
We note that certain insurers are developing policies specifically tailored for IRCs. While these are not yet publicly available, a fund manager may wish to consider these policies rather than simply accepting modified D&O/E&O coverage from its usual insurance broker and insurer.
Compensation: What is the appropriate level of compensation in order to attract quality IRC candidates? The IRC must have the authority to set its own reasonable compensation. We expect that the regulators will encourage the IRC to consider the manager’s recommendation on what would be reasonable compensation. Could a manager be criticized for not playing a role in this process or for recommending compensation that is later seen as overly generous? The corresponding amendments to NI 81-101 will require transparent disclosure of compensation. Will the marketplace appreciate that members of certain IRCs should receive more compensation than members of other IRCs to adequately compensate them for the greater amount of work involved, the complexity of the issues, and, yes, greater liability exposure than would be common to all IRCs? Under NI 81-107 these amounts must, at least initially, be paid by the fund. However, NI 81-107 will allow a manager to reimburse a fund for amounts paid to the IRC provided this is made transparent through prospectus disclosure. If this is done, how will it be perceived? Favourably – keeping the fund from bearing an expense? – or – unfavourably – creating an unholy alliance with the IRC members?
Documenting decisions made by fund managers, including reasons for those decisions, will be very important in this area of indemnities, insurance and compensation.
What’s next? Please watch for our next Practice Bulletin in BLG’s Countdown to Governance series – Practice Bulletin No. 4 will cover what you and your IRC need to do to get started. Please contact your usual lawyer in BLG’s Investment Management Group if you have any questions about NI 81-107 and the matters outlined in this Practice Bulletin.
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.
