On March 27, 2013, the Canadian Securities Administrators (CSA) published for comment proposed amendments to National Instrument 81-102 Mutual Funds (NI 81-102), together with proposed amendments to certain other instruments governing investment funds (the Proposals). 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 of the topics discussed in the Proposals that could impact mortgage investment entities (MIEs) specifically.
To access a complete copy of the Proposals, please click here. For a more general summary and discussion of the Proposals, please see our April 2013 Blakes Bulletin: Securities Regulators Propose New Regime for Closed-End Funds.
HOW MIEs ARE CURRENTLY REGULATED
CSA Staff Notice 31-323 Guidance Relating to the Registration Obligation of Mortgage Investment Entities (the Staff Notice), published February 25, 2011, provides guidance on how the registration requirements of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) apply to MIEs. The Staff Notice seeks, in respect of the jurisdictions of Canada other than Alberta, to distinguish MIEs that are investment funds from those that are not, primarily on the basis of whether an MIE's business could be considered to be the lending of funds secured by mortgages and the administration of such mortgages (in which case the MIE would not be considered to be an investment fund), or whether the business could be best characterized as the holding of mortgages as part of an investment portfolio (in which case the activities of the MIE would be considered to be that of an investment fund).
For Alberta, the Staff Notice indicated that application of the general principles of the Companion Policies to NI 31-103 and National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106) discussing the nature of investment funds should drive the determination. Those general principles defining an investment fund are outlined in section 1.2 of the Companion Policy to NI 81-106 as follows:
"The general nature of an investment fund is that the money invested in it is professionally managed on the basis of a stated investment policy, usually expressed in terms of investment objective and strategies, and is invested in a portfolio of securities. The fund has the discretion to buy and sell investments within the constraints of its investment policy. Investment decisions are made by a manager or portfolio adviser acting on behalf of the fund....
An investment fund can be distinguished from holding companies, which generally exert a significant degree of control over the companies in which they invest...."
The activities of venture capital and private equity investing are also described in section 1.3(b) under the heading "Business Trigger Examples" in the Companion Policy to NI 31-103. These funds are similarly distinguished from investment funds because the venture capital and private equity management company "is actively involved in the management of the companies it invests in," and as a result, the investment portfolio would generally not be considered to be an investment fund.
KEY PROVISIONS FOR MIEs UNDER THE PROPOSED NI 81-102 AMENDMENTS
The proposed amendments would preclude CEFs from investing in other than guaranteed mortgages as part of a package of investment restrictions that the CSA propose to adopt as part of the Proposals.
The CSA are of the view that mortgages that are not fully and unconditionally guaranteed by a government or government agency may not be appropriate investments for publicly offered investment funds. The CSA do not state the basis for that concern. However, the CSA are not saying that these investments are not appropriate for Canadian retail investors.
While the guidance on whether the activities of an MIE would disqualify it from being an investment fund have never been entirely clear, the prohibition of non-guaranteed mortgage would, with a single amendment, disqualify all public mortgage investment entities from investment fund status. Given that MIEs have historically relied on their status as investment funds to list their securities on the TSX, it is unclear how listed MIEs would be launched in the future.
Under the Proposals, the CSA propose that MIEs would, within a 24-month transition period, amend their investment objectives, strategy and restrictions, divest of non-guaranteed mortgages, or transition out of investment fund regulation.
It is anticipated that the general operational requirements 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, including the prohibition on non-guaranteed mortgages, will require additional consideration and are expected to be adopted concurrently with the adoption of the Alternative Funds Rule. For a discussion of the Alternative Funds Rule, please see our April 2013 Blakes Bulletin: Securities Regulators Propose New Regime for Closed-End Funds.
The Proposals, unfortunately, leave some key issues unresolved, which we believe must be clarified in order to permit the creation of a clear regulatory regime for MIEs going forward.
First, the Proposals appear to affirm the continuing guidance provided by the Staff Notice. However, the Staff Notice does not provide guidance on whether the normal activities of most MIEs (namely, both initiating/managing mortgages and investing in third-party mortgages as part of a portfolio) would permit them to continue to be investment funds, and so uncertainty will continue in that area. The Staff Notice indicates some disparity of views among the members of the CSA. Harmonization of these views would be an extremely useful project to be undertaken in conjunction with the finalization of the Proposals. Until the CSA clarify their views on this point, it will continue to be problematic for MIEs to know, as a threshold issue, whether their structure and activities will be considered by the CSA to constitute an investment fund.
Second, some clarification is needed on the options available to MIEs that intend to invest in non-guaranteed mortgages. At least three options seem possible: (a) the MIE could be considered to be an investment fund by the CSA and would simply be prohibited from investing in non-guaranteed mortgages; (b) the MIE could elect to become an alternative fund under that proposed regime, the details of which have not been determined; or (c) the MIE could elect (or be deemed) not to be an investment fund at all and would become subject to the ordinary disclosure and issuer requirements applicable to non-fund issuers. As indicated above, this would raise uncertainties as to how such vehicles would be listed on the Toronto Stock Exchange (TSX), given the current TSX rules. In addition, such vehicles presumably would not be required to have their activities administered by registered investment fund managers and portfolio advisers.
REQUEST FOR COMMENTS
The CSA have requested feedback on specific questions related to the Proposals, which are set out in Annex A and Annex B to the Proposals, including the following questions that relate to MIEs:
the impact of the proposed restriction on non-guaranteed mortgage investments, presumably on the MIEs themselves
the appropriate length of the transition period
the appropriateness of alternatives to a transition period (such as grandfathering)
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.