On August 12, 2011, the Canadian Securities Administrators (CSA) published for comment proposed amendments (Stage 2 Amendments) to National Instrument 81-101 Mutual Fund Prospectus Disclosure to implement Stage 2 of the point-of-sale (POS) disclosure regime. The Fund Facts document is the cornerstone of POS. This bulletin:
- summarizes the Stage 2 Amendments, and
- discusses certain substantive issues with the Stage 2 Amendments, including important differences in how POS is being implemented in the segregated funds industry.
Advancing the POS Implementation Timeline
Stage 1 of POS came into force on January 1, 2011 and now requires that every existing mutual fund currently in distribution using a simplified prospectus file Fund Facts on SEDAR. Fund Facts also must be posted on the mutual fund's or mutual fund manager's website and delivered to investors, on request, free of charge.
Stage 2 of POS will require that Fund Facts be delivered to investors in lieu of the mutual fund's simplified prospectus. The timing for delivery of Fund Facts will be the same as currently required for a simplified prospectus, namely within two business days after the investor's purchase order is accepted. The mutual fund's simplified prospectus will be delivered only if requested by the investor. To this extent, the Stage 2 Amendments contain no surprises. Various consequential amendments to securities legislation are required in order to implement Stage 2, including to preserve the rights of investors for misrepresentation or non-delivery or to withdraw from their purchase. There is no fixed date for enacting Stage 2, but it likely will occur within twelve months.
Under the Stage 2 Amendments, the Fund Facts, when delivered, may be bound only to other Fund Facts required to be delivered to the investor at that time, as well as to the simplified prospectus and any documents incorporated by reference therein (e.g., the annual information form, financial statements and management reports of fund performance) and the trade confirmation relating to the purchase. The Fund Facts cannot be bound to any other document (such as Fund Facts for securities of mutual funds the investor is not then purchasing, or marketing materials). When bound to other documents, the Fund Facts must be the first document, but may be preceded by a cover page, table of contents and trade confirmation.
Changes to Fund Facts
The Stage 2 Amendments contain proposed changes to certain prescribed information in the Fund Facts. The principal changes are summarized below.
Further Disclosure of Annual Account-Level Fees
In the course of reviewing Fund Facts earlier this year, staff at the Ontario Securities Commission (OSC staff) determined that they would like Fund Facts to include disclosure of annual fees charged directly to investors. Specifically at issue are:
- annual dealer compensation charged to investors using fee-based accounts, and
- annual management fees charged by mutual fund managers directly to investors (typically for institutional clients).
Currently, this disclosure is not required. Instead, Fund Facts disclose charges triggered by a purchase, switch or redemption (such as commissions and redemption fees) and the mutual fund's annual expenses (both its management expense ratio and trading expense ratio). Neither of these descriptions captures annual account-level fees.
When enacted, the new disclosure will be contained in the "Other Fees" portion of the Fund Facts. Until then, OSC staff has indicated it may refuse to grant a receipt for a prospectus or prospectus amendment that does not contain such disclosure in the Fund Facts. The additional disclosure also is part of the terms of the discretionary relief granted in August 2011 to permit various mutual fund organizations to proceed early to Stage 2 delivery.
Fund Facts will be permitted to disclose FundSERV (or similar) codes relevant to the mutual fund and class/series of securities described in the Fund Facts. Currently, the CSA are permitting this disclosure through discretionary relief.
Technical Issue with the Stage 2 Amendments
Part of the new annual account-level fee disclosure is prescribed in a revised Instruction (2) to Item 1.4 of Part II in 81-101F3. As currently drafted, the Stage 2 Amendments will require that the Fund Facts disclose, where possible, the highest possible rate of such fee if it is variable. A mutual fund typically has no control over the fees charged by dealers for fee-based accounts, and may not know the range of such fees. Over time, however, the CSA may begin requesting some form of disclosure of the range. A more appropriate approach would be for the Stage 2 Amendments to acknowledge that such disclosure is required only for management or other fees charged by the mutual fund or its manager, and not by third parties.
Substantive Issues with the Stage 2 Amendments
Differences from Segregated Funds
Despite POS being an effort of the Joint Forum of Financial Market Regulators (Joint Forum) to achieve a stated goal of greater harmonization between the regulation of mutual funds and segregated funds, significant differences have not been addressed and persist:
- Securities laws require that the mutual fund's simplified prospectus (or Fund Facts under Stage 2) be delivered to an investor with each purchase of mutual fund securities by the investor (unless the investor already has received the most current version of such document). By comparison, the information folder (the closest equivalent in the segregated funds industry to a simplified prospectus) or Fund Facts is required to be delivered to an investor only when the investor makes his or her first investment in the segregated fund family.
- An insurance company (or its agent) is permitted to deliver to an investor all Fund Facts for all segregated funds, classes and series at the time the investor makes his or her first investment in the segregated fund family. The insurance company also is permitted to bind all Fund Facts together in a single booklet and disclose all repetitive information once in an introductory section to the booklet. By comparison, a mutual fund is permitted to deliver to an investor only the Fund Facts relevant to the mutual fund securities then being purchased by the investor and cannot utilize a similar introductory section approach. These are differences which, in the segregated funds industry, greatly reduce costs and simplify the dissemination of Fund Facts.
- The Fund Facts for a segregated fund may include information for all classes and series offered by the fund in the same document. For a mutual fund, each class or series must have its own Fund Facts. The differences between classes and series of a segregated fund can be material since they often relate to differing levels of capital guarantees and associated fees provided by the class or series.
No Meaningful Cost-Benefit Analysis
Despite repeated requests from the investment funds industry and a requirement to that effect in the rule-making process, there has been no meaningful cost-benefit analysis performed by the CSA on POS. The notice accompanying the Stage 2 Amendments cross-references the cost-benefit discussion in the CSA's June 2009 notice and request for comments on POS. Such previous discussion did not attempt to quantify costs and benefits associated with POS, nor has it been subsequently revisited in any meaningful manner. A truly meaningful cost-benefit analysis would include testing two sample investor groups – one using Fund Facts and the other not using Fund Facts – to determine whether the group using Fund Facts would be more successful at selecting mutual funds suitable for them.
Merits of POS
The overall merits of POS remain questionable. In the absence of significant investor education, additional disclosure may provide only a false sense of knowledge to investors who lack sufficient financial literacy. In Proposed Framework 81-406 Point of Sale Disclosure for Mutual Funds and Segregated Funds published by the Joint Forum in June 2007, the regulators acknowledged that overall knowledge by investors of basic investment concepts is low, and that many investors overestimate their investment knowledge and abilities. For this reason, the Joint Forum's consultation paper published in February 2003 proposed an investor education guide to mutual funds and segregated funds, which was later abandoned. There is nothing to indicate that financial literacy in Canada has improved materially since then.
Registered financial advisors are required to complete prescribed courses and work full time in the mutual fund industry before being considered proficient to recommend mutual funds to clients. This training cannot be replicated in a four page Fund Facts document. In designing and implementing POS, the CSA have not acknowledged the important role played by financial advisors in bridging the gap between an investor's knowledge and the suitability of a mutual fund for that investor.
Stage 3 Ahead
The CSA continue to state that, in due course, they will proceed to Stage 3 of POS. Matters that may be raised and addressed at Stage 3 include:
- requiring that Fund Facts be delivered to investors prior to submission of their purchase orders, which would require substantial changes to the current prospectus delivery infrastructure in the industry,
- mandating the form of risk methodology used in describing the suitability of a mutual fund for particular investors,
- introducing a requirement to provide a comparison of the mutual fund's past performance to a benchmark (as currently is the case in management reports of fund performance), and
- extending POS to other investment fund products.
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.