On February 9, 2012, the Canadian Securities Administrators published final rule amendments to complete Phase 1 of the CSA's two-stage project launched in 2010 to modernize the regulation of mutual funds, including exchange-traded funds, and other investment funds. Subject to ministerial approval, the rule amendments, other than the new restrictions that will apply to money market funds, will be effective on April 30, 2012. Money market funds have a six month transition to the new requirements, and will be required to comply with the new restrictions by October 30, 2012 (being six months from April 30).
The rule amendments [available here] affect National Instrument 81-102 Mutual Funds and National Instrument 81-106 Investment Fund Continuous Disclosure in particular, but amendments to the national instruments prescribing prospectus disclosure for investment funds were also made – National Instrument 81-101 Mutual Fund Prospectus Disclosure and National Instrument 41-101 General Prospectus Requirements.
The amendments will:
- Facilitate public offerings of exchange-traded funds in Canada by codifying exemptions that have been routinely granted by the CSA to these funds
- Impose new restrictions on money market funds
- Allow mutual funds to engage in limited short selling practices
- Allow mutual funds to use investments in money market funds as "cash cover" for derivative transactions
- Provide additional flexibility for mutual funds wishing to invest in other mutual funds and
- Exempt mutual fund dealers from certain compliance
CSA Modernization Project for Investment Funds
These rule amendments were first published for comment in June 2010 and represent the end of Phase 1 of the CSA's overall rule modernization project, which is intended to look more closely at the regulation of publicly offered mutual funds and other investment funds, in light of market developments. In May 2011, the CSA described their proposed next steps in the modernization project, being Phase 2, which includes proposing rules for closed-end funds, as well as reviewing and making any necessary changes to the investment restrictions for mutual funds, ETFs and closed-end funds. The CSA's stated objective is to identify and address any market efficiency, investor protection or fairness issues that arise out of the differing regulatory regimes that apply to various types of publicly offered investment funds. The Investment Management Group at Borden Ladner Gervais LLP (BLG) have followed the CSA's modernization project and have commented on each applicable publication. Please see the following Investment Management Bulletins at the links provided:
Canadian Regulators Propose Modernized Rules for Mutual Funds: ETFs, Money Market Funds, Short Selling, Fund of Funds Investment Management Bulletin July 2010 Borden Ladner Gervais LLP.
Canadian Regulators Propose to Modernize Investment Fund Regulation Investment Management Bulletin June 2011 Borden Ladner Gervais LLP.
Significant Amendments – Phase 1 at a Glance
Money Market Funds
Other Significant Changes
The amendments codify regulatory exemptions from certain provisions in NI 81-102 that have been commonly granted to exchange-traded funds. These changes will ease the regulatory burden for ETFs by removing the need to apply for routine relief, but do not significantly change the current regulatory regime applicable to these funds. Further rule amendments can be expected as part of the overall CSA modernization project.
- Payment for purchases and redemptions of securities in a combination of cash and securities will be permitted (while this amendment applies to all mutual funds, this rule change is particularly relevant to exchange-traded funds).
- The rules on setting a record date for determining the right of securityholders to receive a distribution by the mutual fund will not apply to exchange-traded funds. ETFs will instead comply with the applicable exchange rules.
- The rules on the process for the transmission and receipt of purchase and redemption orders will not apply to exchange-traded funds; therefore, purchase and redemption orders for securities of exchange-traded funds can be transmitted to, for example, the exchange on which securities of the funds are listed, instead of to the order receipt offices of the funds.
- For exchange-traded funds in continuous distribution, the amendments will permit the redemption price for securities, if a securityholder redeems less than a prescribed number of securities, to be a price that is computed by reference to the closing price of the security on the exchange on which the fund is listed and posted for trading.
For exchange-traded funds that are not in continuous distribution:
- A redemption price that is less than the net asset value of the security otherwise determined will be permitted and redemption proceeds can be paid on a specified date that may be more than three days following the valuation date on which the redemption price was established.
- The fund may borrow cash or provide a security interest over its portfolio assets if the transaction is to finance the acquisition of portfolio securities and the outstanding amount of all borrowings will be repaid on the closing of the initial public offering.
- The fund may bear its organization costs.
- There will be no requirement to file annual compliance reports otherwise required by NI 81-102 and the purchase and redemption sections of NI 81-102 will not apply.
- If the ETF falls within the new definition of "fixed portfolio exchange-traded mutual funds", it will be exempt from the 10 percent concentration restriction for purchases of equity securities by the fund if the purchase is made in accordance with its investment objectives.
MONEY MARKET FUNDS
For the most part, the CSA have adopted changes to the definition of money market fund that were first proposed in June 2010. In response to comments however, the CSA have extended the requirement for the dollar-weighted average term to maturity (calculated based on the actual term to maturity of all securities) to 180 days, from the 120-day limit first proposed.
The amendments will result in the following additional restrictions on money market funds:
- Liquidity requirement. A money market fund will be required to have at least 5 percent of its assets in cash or securities that are readily convertible to cash within one day and 15 percent of its assets in cash or securities that are readily convertible to cash within one week. As a response to the industry's request for further guidance on the meaning of "readily convertible to cash", the CSA explain their views in an amendment to the Companion Policy to NI 81-102, that assets that are "readily convertible to cash" would generally be short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value, such as certain government treasury securities.
- New requirements for floating rate notes. A money market fund will be permitted to hold floating rate evidences of indebtedness only if such securities meet the new reset timing test (being every 185 days) in addition to the existing requirements relating to the market value of the note at each reset date.
- Dollar-weighted average term to maturity limit. A money market fund will be required, in addition to the current requirement of maintaining a portfolio with a dollar-weighted average term to maturity limit not exceeding 90 days (calculated on the basis that the term of a floating rate note is the period remaining to the date of the next rate setting of the note), to maintain a dollar-weighted average term to maturity limit not exceeding 180 days (calculated based on the actual term to maturity of all securities, including floating rate notes). The CSA explained their decision not to adopt the shorter 60-day limit, as such exists in the United States and Europe, was due to differences between the money market fund market in Canada and those in the U.S. and Europe.
- Investment restrictions. A money market fund cannot use derivatives or short sell its portfolio securities.
The amendments also codify routine exemptions granted to money market funds to allow them to invest in other money market funds.
The CSA explain that they will continue to monitor ongoing regulatory developments impacting money market funds in other global jurisdictions and consider the need for similar changes in Canada. Compliance with the new money market fund requirements will be required by October 30, 2012 (six months after the other amendments become effective).
Other significant changes to NI 81-102 to be effective on April 30, 2012 include:
- Short selling. Mutual funds will be permitted
to engage in limited short selling, provided that the prescribed
conditions are met, including updated prospectus disclosure and
prior notice being given to investors. The prescribed conditions do
not include all of the same conditions that were previously
required in many exemption orders, and hence further flexibility
will be available. The CSA have clarified, in response to comments,
that they do not expect mutual funds that already engage in short
selling pursuant to regulatory exemptions to provide a second
notice to investors, where they have already notified investors of
However, the CSA cautioned that mutual funds intending to increase their current short-selling activities beyond what was previously permitted in applicable exemptions should consider whether such increase would be a material change.
- Use of derivatives. The definition of "cash cover" will be expanded to include evidences of indebtedness in addition to debt of governments and financial institutions, provided certain restrictions are adhered to. Consistent with prior exemptions, cash cover will also include securities of money market funds. In addition, there will no longer be a term limit on specified derivatives.
- Investments in mutual funds. A mutual fund
will be permitted to continue to invest in another mutual fund even
if the underlying fund ceases to offer its securities in the local
jurisdiction, as long as the underlying fund remains a reporting
issuer in the local jurisdiction. In addition, the restriction on a
three-tier fund-on-funds structure does not apply if the fund that
is in the middle of the structure is a "clone fund",
which is defined as a fund that has adopted a fundamental
investment objective to track the performance of another mutual
The CSA decided not to adopt the June 2010 proposal that the definition of "index participation units" be expanded to include securities traded on an exchange in the United Kingdom, on the basis that markets will continue to evolve and the CSA have become aware of certain complex investment strategies frequently used by European ETFs. The proposal would have permitted Canadian mutual funds to invest without restriction in these UK instruments. The CSA explain that they have opted to continue to deal with exemption applications to allow investments in exchange-traded funds the securities of which do not meet the definition of "index participation units" on a case-by-case basis.
- Mutual fund dealers. The exemption currently applicable to members of IIROC with respect to the restrictions on the commingling of client moneys, the requirements with respect to interest determination and allocation and the filing of compliance reports will be extended to members of the Mutual Fund Dealers Association of Canada and mutual fund dealers in Québec.
- Use of mutual fund ratings in sales communications. Only ratings or rankings prepared by a "mutual fund rating entity" may be used in sales communications. Additional criteria must be met when including a rating or ranking in a sales communication.
Other amendments were made to NI 81-102, which provide greater clarity on the language used or the meaning of certain terminology. For example, the term "net assets" previously in NI 81-102 has been changed to use the more consistent term "net asset value".
The amendments also include the following changes to NI 81-106, which are applicable to all investment funds that are reporting issuers:
- No aggregation of short-term debt. Investment funds will no longer be allowed to aggregate certain types of short-term debt in the statements of investment portfolio required by NI 81-106.
- Public availability of NAV. Upon calculating the net asset value, an investment fund must make available to the public, at no cost, its net asset value and, unless the investment fund is a scholarship plan, its net asset value per security.
- Terminology relating to soft dollars. The terminology relating to the required note disclosure around soft dollar usage has been modified to fit with National Instrument 23-102 Use of Client Brokerage Commissions, but the difficulties associated with compliance with this note disclosure have not been acknowledged or dealt with.
The CSA decided not to proceed with the proposal to exempt "limited life funds" from the requirement to file an annual information form. The CSA will continue to review requests for relief on a case-by-case basis.
We expect that much of the rule amendments will be welcomed by industry participants, particularly to the extent they codify the technical relief which has been routinely granted by the CSA.
Fund managers with funds that use derivatives, engage in short selling or that are money market funds, will need to review the amendments carefully to determine what changes to compliance, portfolios and operations are needed. In particular, given the extent of the new restrictions on money market funds, we expect that portfolio managers of money market funds will need to review their money market funds' portfolios and take the appropriate steps to re-align the portfolios as necessary, as soon as possible. An understanding of the practical implications of the CSA's new liquidity requirements will also be necessary, as well as the CSA's expectations about prudent compliance practices regarding management of money market funds.
As is evident from the fact that the CSA missed its 2011 goal to finalize these amendments, the CSA received many comments, particularly with respect to additional technical and modernization amendments that commentators considered necessary to NI 81-102. None of these additional amendments were made at this time and we expect that the CSA will add the issues raised to the remaining stage of the modernization project. The issues raised by commentators (including BLG) concerning matters such as fund mergers, investment restrictions as they apply to government securities, gold, silver, commodities and commodity ETFs, mortgages, and changes in manager and changes in control of managers, are important to the Canadian fund industry and deserve both additional regulatory and industry consideration in the near future.
The CSA did not give any indication about the status of their work on Stage 1 of Phase 2 of the modernization project – namely to publish for comment a stand-alone rule applicable to closed-end funds. The time-frame suggested for this proposed rule was early 2012; this timing may not be realistic, given the work taken to finalize the Phase 1 rule amendments and the comments received on the May 2011 publication regarding the CSA's overall modernization project.
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.