The Ontario Securities Commission (OSC) recently published Staff Notice 81-718 – Summary Report for Investment Fund Issuers 2012 (the Report) which provides an overview of the key activities and initiatives of the Investment Funds Branch of the OSC in 2012. The Report includes a summary of the OSC's key policy initiatives, its view on the emerging issues and trends in the industry, results of the OSC's disclosure and compliance reviews and an update on recent developments in staff practices.
This bulletin summarizes certain topics discussed in the Report. To access a complete copy of the Report, please click here.
KEY POLICY INITIATIVES
Modernization of Investment Fund Product Regulation
The Canadian Securities Administrators (CSA) concluded Phase 1 of the modernization project in February 2012 by publishing amendments to National Instrument 81-102 – Mutual Funds (NI 81-102) and National Instrument 81-106 – Investment Fund Continuous Disclosure (NI 81-106) which, among other things, introduced new provisions to address certain purchase and redemption processes and other operational requirements of exchange-traded funds (ETFs), added restrictions for money market funds, and permitted mutual funds to engage in short selling.
In Phase 2 of this initiative, which is currently underway, the CSA are focused on developing core investment restrictions and operational requirements for publicly offered non-redeemable investment funds. The CSA are expected to publish shortly additional amendments to NI 81-102 and potentially National Instrument 81-104 – Commodity Pools (NI 81-104) that will create a uniform framework for investment products. It is expected that the CSA will propose changes pursuant to which NI 81-104 will apply to both mutual funds and non-redeemable investment funds that use investment strategies that would not be permitted under the proposed amendments to NI 81-102. Specific issues that the CSA are considering for non-redeemable investment funds in Phase 2 include conflict of interest provisions, custodianship requirements to safeguard the assets of the fund, and most importantly, a set of core investment restrictions including a limit on leverage that may be used by such funds.
Also in Phase 2, the CSA will consider potential investment restrictions for open-end mutual funds and exchange-traded mutual funds under Part 2 of NI 81-102 and may examine investment restrictions related to physical commodities and derivatives. The CSA plan to publish the Phase 2 proposals for comment early in 2013.
Fund Facts Initiative and Fee Structure Reviews for Mutual Funds
In response to stakeholder feedback, the CSA published for further comment its proposed amendments to National Instrument 81-101 – Mutual Fund Prospectus Disclosure (NI 81-101) in June 2012. The amendments focus primarily on the presentation of risk and performance in Fund Facts. The comment period expired in September 2012 and the Report noted that the testing of new content with investors was completed in October 2012. Results of the review and the CSA's final proposals are expected to be published in summer 2013.
In Stage 3 of the Points of Sale Project, the CSA expect to publish for further comment proposed rules that would implement point of sale delivery for mutual funds. As part of this project, the CSA is also considering the applicability of Fund Facts-type document and point of sale delivery for other types of publicly offered investment funds such as closed-end funds and ETFs. Additionally, the CSA is working on a risk rating methodology for use in Fund Facts and will consult and issue a request for comment on any proposed methodology.
In December 2012, the CSA also published a consultation paper to initiate a review of the mutual fund fee structure. The CSA reiterated that the aim of this initiative is to improve investor protection, and, as set out in the Report, this initiative may be extended to other investment funds and comparable securities products as well. The paper is currently out for comment and the CSA plan to hold a roundtable on this topic with investors and industry participants in 2013.
EMERGING ISSUES – INNOVATIVE SECURITIES AND NOVEL PRODUCT OFFERINGS
As set out in NI 81-102, mutual funds may invest in Canadian or U.S. exchange listed ETFs that track a "widely quoted market index" (such securities being an index participation unit, or IPU). The Report expresses a concern regarding mutual funds seeking discretionary relief to invest in ETFs listed on foreign exchanges (Foreign IPUs) where the ETFs are not in fact 'market indices'. Rather, some Foreign IPUs may provide exposure to asset classes or strategies that a mutual fund would not be able to invest in directly, for instance, tracking the price of a commodity or the performance of hedge funds. Consequently, the OSC has been reluctant to grant exemptions to permit mutual funds to invest in such Foreign IPUs.
The Report sets out a list of items that the OSC typically considers in its review of such applications. In summary, staff generally looks unfavourably on Foreign IPUs utilizing synthetic replication strategies, but has allowed discretionary relief to permit investment in Foreign IPUs up to a specified limit where:
- the Foreign IPU is subject to a regulatory framework similar in substance to that in Canada; and
- the fund can demonstrate that the investment in Foreign IPUs is consistent with, and fundamental to, the investment objectives of the fund.
Investment in Physical Commodities
Staff also noted that it has generally been prepared to recommend discretionary relief for mutual funds, other than precious metal mutual funds, to permit such funds to invest up to 10% of its net asset value in gold and/or silver to achieve asset diversification, and has recommended relief to permit funds with objectives to provide exposure to a particular sector or industry to invest up to 10% of their net asset value in physical commodities related to the sector or industry. However, the Report notes that staff has generally taken the view that investments in physical commodities by conventional mutual funds, other than precious metal funds, in excess of 10% of net asset value of the fund are not consistent with the nature of a mutual fund as a diversified portfolio of securities.
DISCLOSURE AND COMPLIANCE REVIEWS
Advertising and Marketing Materials
In 2012, the Investment Funds Branch conducted targeted reviews of advertising and marketing materials of investment fund managers of mutual funds, closed-end funds, ETFs, commodity pools and labour-sponsored investment funds. In connection with this initiative, staff reviewed advertising and marketing materials that appeared during the previous quarter in newspapers, presentations, brochures, radio ads, social media, email blasts and green sheets and on the Internet, television and fund managers' websites.
The Report sets out a few common issues that staff noted so far during their review, including:
- inappropriate use of hypothetical data
- use of unsupportable statements
- failure to provide a balanced message on risk/reward
- Internet ads without the required appropriate warning language
- lack of adherence to the requirement to provide standard performance
- use of misleading headlines, or headlines that suggest a degree of safety, a lack of risk, or phenomenal skills or results.
As a result of these reviews, investment fund managers have had to remove certain advertisements, make material changes to sales communications, revise applicable policies and procedures and re-train their staff involved in producing and approving marketing materials. Full results of and guidance arising from this review are expected to be published in spring 2013.
Risk Ratings in Fund Facts
The OSC continued in 2012 a focused review of risk ratings disclosed in Fund Facts. Staff identified underestimation of risk levels by fund managers, as identified by the OSC through comparison with peer funds. Consequently, affected fund managers were required to update their ratings and file an amended and restated Fund Facts, as staff generally take the view that an increase to a mutual fund's risk rating is a material change under securities legislation.
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