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One-third of Canada's largest income trusts do significant side deals with insiders while more than 20 per cent are operated by outsiders under a management contract, a Report on Business review of trust governance has found.

As part of its annual survey of corporate governance in Canada, ROB this year conducted an extensive review of the country's largest income trusts — those trusts recently included in the benchmark S&P/TSX index.

While many large income trusts are making changes that reflect their evolution into mature business giants, ROB found that governance practices are all over the map, with a sizable proportion of trusts still operating in outdated ways rarely seen among large companies in the corporate sector.

For example, 22 per cent of the country's largest trusts continue to be managed under external contracts, which means they do not have in-house management teams who report directly to the board. A further 7 per cent have a combination of internal management and an external management contract.

One-third of trusts did related-party transactions last year valued at more than 1 per cent of the trust's total revenue, opening the door for potential conflicts of interest.

And ROB also found that while trusts don't have dual-class shares like some corporations, that doesn't mean there aren't democratic gaps. Twenty per cent of trusts have at least one director who is unelected while 16 per cent grant voting rights to unitholders or managers that are significantly out of proportion to their ownership stakes.

"There are basically no rules," says Brian Gibson, vice-president of public equities at the powerful Ontario Teachers Pension Plan. "It's like the Wild West."

Investors have flocked to trusts in recent years, praising the steady cash payouts and the disciplined approach to investing capital.

With the recent plans by blue-chip giants such as Telus Corp. and BCE Inc. to join the trust sector, it is fast approaching the $250-billion mark in value.

But that doesn't mean income trust structures have matured at the same rapid pace. And investors are especially concerned that if any problems emerge as a result, they have few legal protections to fall back on.

Corporations are governed by the Canada Business Corporations Act (CBCA) and parallel provincial corporations acts. They outline key obligations of companies and rights of shareholders — such things as the obligation to hold an annual meeting and the right of shareholders to band together to call a special meeting or submit proposals for a vote.

The CBCA also gives shareholders the right to launch a legal challenge whenever they feel their rights have been oppressed by a company.

Because they are not corporations, trusts are not covered by any of this legislation.

In the absence of government-imposed rules, unitholders are left to settle for whatever rights are granted to them when a trust is created. At their inception, all trusts create declarations setting out the rights of investors. But there are no requirements about what has to be included in this document and the rights vary widely.

"The average investor doesn't appreciate that their legal rights are quite different when they invest in a trust, and they may not even have legal rights," Mr. Gibson said.

David Beatty, head of the Canadian Coalition for Good Governance (CCGG), a group of large shareholders, believes Canada has created an industry "with absolutely no regulatory guidelines or oversight. ...

"I really find it astonishing that in an age where corporate governance has received such focus, that a whole major class of assets, widely invested in by ordinary Canadians, has not found an interest in any regulatory agency across the country. It's quite an astounding gap."

Defenders of the industry say the lack of regulation is no reason for investors to dash for the exits. Most trusts do provide some unitholder protection in their trust documents, and just because they are not standardized is no reason for investors to lose sleep, they argue.

"The differences between trust declarations and corporate law are not particularly significant," says Toronto lawyer Stephen Pincus, who heads the governance committee of the Canadian Association of Income Funds, an industry group. "This has become a very important structure for the capital markets and it is so widely used. It would be inaccurate to say that there is some gaping hole."

Teachers and the CCGG have embarked on a quiet campaign to persuade trusts to add a full list of investor protection features to their governing documents. Earlier this year, Teachers and partner Sherritt International Corp. spun off coal producer Royal Utilities Income Fund and tried to include all the rights granted to corporate investors in its declaration of trust.

Mr. Gibson says he wants to position the document as an example of a model trust declaration that others can copy.

At the same time, a group working with the Uniform Law Conference of Canada, an independent law-drafting body, has proposed rules that could be enacted by each province to put trusts on a more equal footing with corporations.

But the growth in the trust sector is not about to wait for regulations to catch up. Money is piling in and conversions continue.

Without rules for the sector, major investors have become the self-appointed cops of this industry, quietly putting the brakes on abuses when they can, pressing for changes to boards and making it clear to underwriters that they will not invest in new issues if they do not like the proposed structures.

"At the end of the day, this is a beauty contest," says Sandy McIntyre, a senior vice-president at Sentry Select Capital Corp. and a long-time investor in income trusts.

"You are looking for people who want to put their capital with you. And lack of transparency increases your cost of capital, makes you less attractive."

One structure some investors say they often avoid is the use of external management contracts, which means large trusts are run under contract by an outside firm. Investors say external management is less transparent and less accountable. It can be less clear which individuals to hold responsible, and it is difficult to get rid of someone for poor performance without cancelling the contract and losing the whole management team.

Depending on the situation, it can also be more expensive to have an external contract than to hire employees to manage the operation. And it can be expensive to cancel the contracts, especially those with long terms.

Even within the sector, external management has been falling out of favour. ARC Energy Trust, for example, got rid of its external management contract four years ago. Chairman Mac Van Wielingen says the trust felt it had too few institutional investors because they didn't like its corporate structure. ARC also implemented other governance reforms, such as eliminating the use of stock options.

"We thought we would benefit by following the highest level of corporate governance," he said. "We could see this was going to become an increasingly significant issue."

But the costs of converting are undeniably high. NAL Oil & Gas Trust restructured its external contract last year, and it cost the trust $30-million to modify the terms and reduce the payments.

Pengrowth Energy Trust considered eliminating its management contract this year. But the board determined it would cost too much to cancel it before the end of its next three-year term in 2009.

Pengrowth's external manager is owned by chairman and chief executive officer James Kinnear. Last year, his firm was paid $16-million to provide management services.

Charles Selby, Pengrowth's vice-president and corporate secretary says the external management contract is not a problem for investors: "Ultimately, what seems to drive investment is performance."

Another governance concern at income trusts is the prevalence of related-party deals, many of which often go hand-in-hand with external management contracts.

Some types of related-party deals include asset purchases and sales involving separate companies owned by an executive of the trust, as well as loans to or from the trust with a related company.

Investors have also complained about cases in which trusts have spun off junior firms, and former managers have left to head them up. In some cases, the managers have received private placements of shares at a significant discount.

"I think there have been some serious abuses of how the insiders have taken certain assets they knew about, and just loaded up themselves," says David O'Brien, a director on the board of Focus Energy Trust, which did a recent spinoff and gave all shareholders the right to participate.

At some trusts, there is little investors can do if they are unhappy about governance issues. Inter Pipeline Fund, for example, is structured as a limited partnership, and there is no requirement to issue a proxy circular or hold an annual meeting. Investors do not have the right to elect directors to the board of the general partner.

This is an extreme example of non-democratic structures in the sector. But 20 per cent of S&P/TSX trusts have at least one unelected director who is simply appointed to the board by a manager or other party. Four of them — Inter Pipeline, Bell Nordiq Income Fund, Epcor Power LP and TransAlta Power LP — have no elected directors: The board is appointed by managers.

Still, as long as retail investors are lining up to buy, even major players say they have limited power to change practices they don't like. When money is flowing into a sector, even trusts with weak practices can find easy financing.

"In a good market, the cop doesn't have any fire power," Sentry's Mr. McIntyre said. "We get to use our clout when they need us."