On March 27, 2013, the Canadian Securities Administrators (CSA) published for comment proposed amendments to securities rules governing investment funds (the Proposals), including National Instrument 81-102 Mutual Funds (NI 81-102), together with proposed amendments to certain other instruments governing investment funds. The Proposals comprise stage one of Phase 2 of the CSA's Modernization of Investment Fund Product Regulation Project (the Modernization Project).
Historically, conventional core operational requirements have not applied to non-redeemable closed-end funds (CEFs), although, like mutual funds, they remain subject to the continuous disclosure and fund governance requirements set out in National Instrument 81-106 Investment Fund Continuous Disclosure and National Instrument 81-107 Independent Review Committee for Investment Funds. In recognition of the evolving structure, characteristics and increasing innovation of the CEF industry, the Proposals seek to impose core operational requirements and investment restrictions upon CEFs that currently only apply to publicly offered mutual funds and exchange traded funds (ETFs).
To preserve flexibility for CEFs so that they are able to continue to provide investors with access to alternative investment strategies, the CSA are also seeking input on an alternative fund framework (the Alternative Funds Rule) for the governance of investment funds whose assets or investment strategies would not be permitted under the proposed amendments to NI 81-102. The Alternative Funds Rule would be effected through amendments to National Instrument 81-104 Commodity Pools (NI 81-104) and would operate in conjunction with the proposed amendments to NI 81-102.
This bulletin summarizes certain topics discussed in the Proposals. To access a complete copy of the Proposals, please click here.
The Modernization Project is a fundamental rethink by the CSA of the regulation of publicly offered investment funds. Pursuant to the Modernization Project, the CSA are considering whether the current regulatory approach sufficiently addresses product and market developments in the Canadian investment fund industry and continues to adequately protect investors.
Phase 1 of the Modernization Project focused primarily on publicly offered mutual funds and was completed once certain amendments to NI 81-102 came into force in April and October 2012. Specifically, the Phase 1 amendments (i) codified certain types of exemptive relief frequently granted in recognition of market and product developments, such as allowing mutual funds to engage in short-selling subject to certain standard restrictions, (ii) expanded the types of "cash cover" that mutual funds could hold in compliance with anti-leverage investment restrictions, and (iii) introduced new provisions to address the unique features of ETFs. The Phase 1 amendments are described in our February 2012 Blakes Bulletin: CSA to Complete Phase 1 of Modernization Project and Amend Investment Fund Rules.
In May 2011, the CSA published CSA Staff Notice 81-322 Status Report on the Implementation of the Modernization of Investment Fund Product Regulation Project and Request for Comment on Phase 2 Proposals (CSA Staff Notice 81-322), which, among other things, provided greater details on the scope and timing of Phase 2 of the Modernization Project. The main objective of the Phase 2 proposals is to address the issues that arise out of the different regulatory regimes that apply to different types of publicly offered investment funds.
Phase 2 of the Modernization Project is divided into two stages. Stage one includes the publication of several proposed amendments that relate primarily to CEF regulation, and stage two is expected to relate to the review of investment restrictions applicable to mutual funds and ETFs in light of market developments.
The CSA acknowledge several fundamental differences between CEFs and mutual funds, namely, that CEFs issue a fixed number of securities pursuant to an initial public offering underwritten by investment dealers, trade on an exchange at market prices that may be at a discount or premium to net asset value (NAV) and generally do not redeem at NAV on a regular basis. However, the CSA have concluded that the differences that the CSA have identified between CEFs and mutual funds do not provide a "sufficient policy basis" to exempt CEFs from some of the core restrictions and practices in NI 81-102 that, in the view of the CSA, are intended to (i) establish parameters to meet the expectations of retail investors, (ii) prohibit activities that are inconsistent with the fundamental characteristics of passive investment vehicles, or (iii) reflect prudent fund management practices.
KEY PROVISIONS FOR CEFs UNDER THE PROPOSED NI 81-102 AMENDMENTS
Of particular interest to CEF issuers is the proposed introduction of core investment restrictions and a new requirement that offering expenses incurred in connection with the CEF's initial public offering may no longer be borne by the fund. It is anticipated that the amendments to NI 81-102 that will apply investment restrictions to CEFs will be adopted concurrently with the Alternative Funds Rule, which is intended to permit CEFs to elect to be "alternative funds" to pursue certain "alternative investment strategies" that would not be permissible under NI 81-102. Except in respect of the alternative investment restriction framework, alternative funds are expected to be subject to all NI 81-102 requirements in the same or a similar manner as CEFs.
The proposed investment restrictions include:
- concentration restriction that would limit a CEF's investment in any issuer to 10% of NAV of the fund as determined at the time of purchase (subject to the existing carve-out provided for "fixed portfolio ETFs" that will apply to permit "fixed portfolio funds" to invest in fixed portfolios of publicly traded equity securities)
- a liquidity restriction that would limit a CEF's investment in illiquid assets to 10% NAV of the fund at the time of investment and 15% thereafter
- a leverage restriction that prohibits a CEF from borrowing cash in excess of 30% of NAV of the fund determined at the time of borrowing; the proposed restriction would also require the fund to only borrow from "Canadian financial institutions," and other anti-leverage provisions would prohibit CEFs from obtaining leverage through the use of derivatives or short selling
- a commodity concentration restriction that would limit a CEF's direct or indirect investment in any particular physical commodity to 10% of NAV of the fund as determined at the time of investment
The proposed NI 81-102 amendments also include a restriction that would prohibit a CEF from investing in CEFs in order to ensure that CEFs do not indirectly obtain leverage beyond the 130% cap imposed through the borrowing restriction. Furthermore, CEFs will be required to comply with existing NI 81-102 rules when investing in mutual funds, including provisions prohibiting duplication of fees.
The Proposals also would require all CEFs to follow the existing requirements in NI 81-102 with respect to securities lending, repurchase and reverse repurchase transactions, and the CSA have asked for feedback to specific questions regarding detailed disclosure requirements regarding investment funds' securities lending, repurchase and reverse repurchase transaction activity that are under consideration and are intended to increase the transparency of the benefits, costs and risks associated with these activities.
The Proposals would prohibit the expenses incurred in connection with a CEF's initial public offering from being borne by the fund. The CSA believe that this will align the interests of CEF managers with those of their investors and increase the efficiency of CEF launches. However, the CSA acknowledge that this proposed change may adversely limit the ability of managers to launch new funds or restrict smaller funds from reaching the marketplace. We note that this proposed change constitutes a reversal of the position advanced by the CSA with respect to offering expenses for ETFs in connection with the amendments to Section 3.3 of NI 81-102 adopted last year. ( See CSA Notice of Proposed Amendments to NI 81-102 Mutual Funds and NI 81-106 Investment Fund Continuous Disclosure, and Related Consequential Amendments – "Organizational Costs" (2010) 33 OSCB 5835).
As CEF managers already cap offering expenses (excluding commissions) at 1.5% of gross proceeds of an offering, the benefit to investors of this proposed rule will be limited, and consequently, we expect that the cost/benefit analysis of this proposal will be the subject of considerable commentary. Additional consideration may also be given to the potential effect that this new rule may have on ongoing management fees and the redemption rights customarily provided to CEF investors.
The Proposals would require that CEFs comply with the current mutual fund rules governing conflicts of interest, securityholder approval matters, custodial rules and performance fees as set out in Parts 4, 5, 6 and 7 of NI 81-102. At a high level, these changes are not expected to significantly affect CEF issuers, and the custodial rules (and related restrictions on pledging of portfolio assets), in particular, generally apply to most CEFs due to rules currently included in National Instrument 41-101 General Prospectus Requirements.
Issuances, Sales Communications and Redemptions
The Proposals would require that future issuances be effected on a basis that is not dilutive to existing securityholders and would specifically prohibit the issuance of warrants, rights or other specified derivatives, the underlying interest of which is a security in the fund. The Proposals would require all future issuances of securities by a fund to be priced at NAV plus a premium to account for the expenses of the secondary offering. To avoid some of the uncertainty that the Proposals would introduce, it may be advisable that the CSA adopt current market practice that generally requires that secondary offerings are not dilutive to current securityholders and that the offering price on the NAV of the class of securities being offered be based on the NAV determined on the day before the date on which the price for the offering is set.
The CSA also propose to cause section 15 of NI 81-102 (Sales Communications), including the calculation of performance data, to apply to CEFs after the completion of their initial offering.
With respect to redemptions, the Proposals mandate two items that are consistent with standard market practice within the CEF industry. First, the Proposals would require CEFs to provide a reminder notice to investors concerning annual redemptions (a service that is routinely provided by CDS Clearing and Depository Services Inc.) and, second, a requirement to fund redemptions within 15 business days following a redemption date.
One specific question posed by the CSA is whether a fund that permits redemptions at NAV even as infrequently as annually ought to be considered to be a mutual fund. Commentators may wish to consider whether the intended benefits of this change could be outweighed by the detriment to investors if CEFs were prohibited from providing annual redemptions at NAV.
The Proposals would subject CEFs to the rules relating to incentive fees currently applicable to mutual funds. The most significant aspect of this change would be to require the receipt of incentive fees to be based on performance measured against a benchmark or index that is publicly available and reflects the market sector in which the fund invests according to its investments' objectives.
Mergers and Conversions
The Proposals would require securityholder approval before changing a fund from one type of investment fund to another, or converting or merging an investment fund to or with an issuer that is not an investment fund. The Proposals also would prohibit the costs and expenses related to such mergers and conversions from being borne by the fund though query whether conversions undertaken in response to the Proposals such as those to be undertaken by mortgage investment entities should be borne by fund managers. In this regard, the CSA's guidance on responses to the character conversion measures recently announced by the Minister of Finance will be of interest.
Under the Proposals, a CEF that has an automatic conversion feature may be exempt from the securityholder approval requirement if it meets specified criteria, including disclosure of the event triggering a conversion in its initial public offering prospectus, certain sales communication disclosure and prior notice to securityholders. Under the Proposals, any sales communications for a mutual fund that has converted from a CEF must, in order to present performance data, also present past performance data of the CEF. A merger of a CEF into a mutual fund may also be exempt from the requirement if it meets certain specified criteria that currently apply under NI 81-102 to permit mergers between mutual funds managed by the same manager (or by affiliates) without securityholder approval. An exemption would also be available for flow-through funds in connection with their rollover into a mutual fund.
Timing of Implementation of the Proposals and Transition Periods for Existing Funds
It is anticipated that the general operational requirements discussed above that do not impose investment restrictions on CEFs would come into effect before the adoption of the proposed investment restrictions. It is anticipated that the investment restrictions will require additional consideration and are expected to be adopted concurrently with the adoption of the Alternative Funds Rule discussed below.
Under the Proposals, the CSA propose an 18-month transition period for existing CEFs to comply with core investment restrictions that are approved by the CSA to allow existing funds time to adjust their portfolios and to organize their affairs. However, any CEFs that are launched after the date the Proposals are brought into force would be required to comply from inception with the proposed investment restrictions. An 18-month transition period is also proposed for compliance with Part 7 (Incentive Fees) of NI 81-102, and a six-month transition period is proposed for existing CEFs to continue to use sales communications, other than advertisements, that were prepared prior to the date the Proposals pertaining to Part 15 of NI 81-102 are brought into force.
The importance of a grandfathering mechanism will depend in part on how accommodating the proposed Alternative Funds Rule is seen to be.
KEY PROVISIONS OF THE ALTERNATIVE FUNDS RULE
The Alternative Funds Rule is intended to provide an alternate framework of investment restrictions for both CEFs and mutual funds that pursue investment strategies not permitted under NI 81-102, such as strategies that focus on alternative asset classes or use alternative investment strategies.
Currently, NI 81-104 applies only to specialized mutual funds that are "commodity pools" by exempting them from certain restrictions contained in NI 81-102. The Alternative Funds Rule is intended to preserve the flexibility for CEFs to use alternative strategies and, at the same time, create a more comprehensive framework for alternative investment funds. As part of its review of NI 81-104, the CSA are also considering whether new prospectus disclosure, continuous disclosure and sales communication requirements would be appropriate for investment funds that wish to use alternative investment strategies and whether there is a need for additional proficiency requirements for the sale of alternative fund securities. The CSA have not yet published a draft of the proposed amendments to NI 81-104, and it is therefore unclear how the proposed Alternative Funds Rule would be structured and what the consequences would be to a fund carrying on as an alternative fund.
The following are the key elements of the Alternative Funds Rule that will inform the CSA's proposals relating to both NI 81-104 and NI 81-102 as set out in the Proposals.
The CSA are seeking feedback on the following preliminary key investment restrictions:
- a concentration restriction that would permit the fund to invest a larger percentage of NAV of the fund in the securities of a single issuer than would be permitted under NI 81-102
- an exemption to permit a fund, other than existing "precious metals funds," to invest in physical commodities or specified derivatives linked to physical commodities
- a provision allowing fund-of-fund structures, including allowing an alternative fund to invest in other alternative funds provided that the underlying funds are reporting issuers in the same jurisdiction as the fund but prohibiting investment in underlying funds that are foreign investment funds or Canadian-based investment funds that are offered under prospectus exemption
- a restriction on borrowing cash that is currently proposed to be capped at 50% of NAV of the fund
- a short-selling rule that would cap short exposure to any one issuer to 10% of NAV of the fund and aggregate short exposure to 40% of NAV of the fund, each calculated at the time of the short sale; a related provision would exempt the fund from a requirement to hold cash cover pursuant to NI 81-102
- maintaining the current exemption from the NI 81-102 derivatives rules that is currently available in NI 81-104 and that permits funds to create leverage through the use of specified derivatives
- a restriction prohibiting an alternative fund from providing returns of more than two times the existing daily positive or inverse return of an underlying interest that the fund seeks to track
- the repeal of an existing exemption in NI 81-104 from the counterparty exposure exemption contained in NI 81-102, that would otherwise permit market exposure under specified derivatives to a counterparty that is not an acceptable clearing corporation exceeding 10% of NAV of the fund for a period of 30 days or more
- a leverage limit (aggregating leverage employed by underlying funds) of 3:1 to be observed at all times
In addition, the CSA seek feedback on whether there are additional investment strategies for alternative funds that the Alternative Funds Rule should permit or restrict.
All alternative funds may also be required to include the words "alternative fund" in the fund name.
Initial Public Offerings
The launch of an alternative fund would involve several unique elements including:
- bold text-box disclosure may be required on the face page of prospectuses highlighting that the risks of the fund may differ significantly from the risks of other investment funds
- similar bold text-box disclosure on marketing materials
- additional proficiency requirements may potentially be imposed on individual dealing representatives who sell alternative fund securities, such as additional experience or additional courses
Depending on the nature of the proficiency requirements, the viability of the alternative funds regime could be significantly diminished.
Disclosure of Complexity
The CSA are seeking feedback on methods of measuring and disclosing leverage for alternative funds given that different measures of risk are associated with different types of leverage. The CSA are also considering requiring alternative funds to provide monthly website disclosure of maximum and average daily amounts of leverage and requiring rolling drawdown disclosure. Managers of complex products are familiar with risk management techniques, and these managers will be in a position to contribute significantly to the dialogue on this point.
CSA Request for Comments
The CSA have requested feedback on specific questions related to the NI 81-102 amendments set out in Annex A to the Proposals and also welcome feedback on all aspects of the Alternative Funds Rule as well as specific issues set out in Annex B to the Proposals, including with respect to the transition periods that will apply to a CEF and the period of notice that should be given to investors in order for a CEF to become an alternative fund.
Comments are requested by the CSA on or before June 25, 2013.
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.