Phase 2 of the modernization of investment fund product regulation project
The Canadian Securities Administrators (CSA) published for comment proposed changes to the regulatory regime governing investment funds on March 27, 2013. The proposed changes are primarily focused on amendments to National Instrument 81-102 (NI 81-102) that are aimed at bringing non-redeemable investment funds (or closed-end funds) into the regulatory framework that governs open-end mutual funds and introduces core operational requirements and investment restrictions on closed-end funds. The CSA also seek feedback on an "alternative fund framework" that would see the overhaul of National Instrument 81-104 (NI 81-104), which currently governs commodity pools, as a regulatory regime for both open-end mutual funds and closed-end funds that focus on alternative asset classes or use alternative investment strategies not permitted by NI 81-102 as proposed to be amended.
The publication of these proposed changes marks the "first stage" of Phase 2 of the CSA's modernization of investment fund product regulation project (Modernization Project) that has been underway since 2010. Phase 1 of the Modernization Project, which came into force in 2012, focused on, among other things, publicly offered mutual funds and the codification of frequently-granted exemptive relief. With Phase 2, the CSA seek to address perceived market efficiency, investor protection and fairness issues that arise out of the different regulatory regimes that apply to various investment products with a view to streamlining the regulation of publicly-offered investment funds.
The proposed amendments also impact open-end mutual funds.
The following is a summary of some of the significant changes proposed by the CSA.
Key proposals affecting closed-end funds
IPO offering expenses – no longer borne by the fund?
One proposal intended to level the playing field with other types of investment funds is a proposed prohibition on closed-end funds bearing the organizational expenses of an initial public offering (IPO). This change would require fund managers to bear the costs of launching a new product, which would be a change from the prevailing market practice of having the fund pay the organizational costs from the proceeds of its IPO. In its commentary, the CSA recognize that this change would impact managers that cannot independently finance organizational costs and that smaller managers may be unable to launch new products. While the shifting of financial risk is intended to align the interests of managers and investors, and possibly lead to cost efficiencies when launching new funds, in recognition of the impact on fund managers, the CSA are specifically seeking comments on the cost-benefit considerations associated with this proposal and whether specific components of IPO costs might be appropriately allocated between the manager and the fund.
Core investment restrictions
The CSA proposal sets out several investment restrictions that would apply to closed-end funds, which are derived from those applicable to open-end mutual funds, including restrictions:
- prohibiting a closed-end fund from investing more than 10% of
its net asset value in a single issuer (although "fixed
portfolio exchange-traded funds" would be permitted to exceed
this limit with respect to fixed portfolios of publicly traded
- prohibiting a closed-end fund from investing more than 10% of
its net asset value in physical commodities (and specified
derivatives with underlying interests in physical
- limiting a closed-end fund's investment in illiquid assets
(as defined in NI 81-102) to 10% of its net asset value at the time
of investment, and 15% thereafter;
- prohibiting a closed-end fund from borrowing cash in excess of
30% of its net asset value, limiting the sources of cash borrowing
to "Canadian financial institutions", and prohibiting a
closed-end fund from obtaining leverage through specified
derivatives or short selling; and
- with respect to "fund-of-fund" structures, prohibiting investment in other non-redeemable investment funds and extending existing restrictions in NI 81-102 (applicable to mutual funds) to closed-end funds where a fund-of-fund structure involves underlying mutual funds.
Several of the proposed changes involve the extension of NI 81-102 operational requirements (applicable to mutual funds) to non-redeemable funds with certain modification or alternative requirements. These include the extension of:
- the conflicts of interest provisions in Part 4 of NI
- the custodial requirements in Part 6 of NI 81-102 which would
be similar to the custodial requirements currently applicable to
most closed-end funds under National Instrument 41-101;
- the provisions governing performance fees in Part 7 of NI
81-102 (i.e., requiring performance to be measured against a
benchmark or publicly-available index reflecting the market sector
in which a fund invests);
- the provisions of NI 81-102 relating to securities lending,
repurchase and reverse repurchase transactions and limiting the
aggregate market value of securities loaned or sold to no more than
50% of a fund's net asset value;
- the securityholder and regulatory approval requirements of Part
5 of NI 81-102 with respect to changes that impact a fund or its
- the rules governing sales communications in section 15 of NI 81-102, including the calculation of performance data (though allowing the presentation of past performance data for funds that convert to mutual funds from closed-end funds).
The CSA seek to require closed-end funds to provide a reminder notice to investors with respect to the procedures for exercising annual redemption rights, to pay redemption proceeds not more than 15 business days following the redemption date, and to not redeem securities at a redemption price exceeding the net asset value on the redemption date. The proposals would permit closed-end funds to suspend redemptions in accordance with the requirements of NI 81-102 that apply to open-end mutual funds. The CSA currently take the view that funds redeemable on demand at net asset value no more than once a year are considered to be non-redeemable investment funds. Of note, the CSA are seeking comment as to whether they should reconsider their position.
Prohibition on warrant offerings
The proposal would prohibit an investment fund from issuing warrants, rights or other specified derivatives in which the underlying interest is a security of the fund. The CSA take the position that such issuances could dilute the value of securities of a fund held by investors who do not exercise the warrants. The CSA have expressed the view that warrant offerings may "appear to be coercive, with securityholders obligated to make an additional investment or face the risk of dilution".
Fund conversions and mergers
The CSA propose to mandate securityholder approval for the implementation of changes to the nature of an investment fund, specifically with respect to the conversion of a closed-end fund to a mutual fund, as well as the conversion of an investment fund to an issuer that is not an investment fund. Closed-end funds with automatic conversion features would be exempt from the securityholder approval requirement if the fund has been structured since inception to convert to a mutual fund and certain conditions are met, including prospectus and sales communication disclosure of the conversion and prior notice to securityholders. In addition, exemptions may be available with respect to mergers and rollovers involving funds that have a limited life and that do not list or trade on a secondary market (e.g., flow-through limited partnerships) if certain disclosure and other requirements are met. Additional conditions are being proposed to allow mergers to be effected without securityholder and regulatory approval when a closed-end fund offers to redeem its securities at net asset value before the merger and the merger is effected at net asset value.
Under the proposals, a closed-end fund would be prohibited from bearing the costs and expenses associated with a merger or conversion.
Alternative fund framework
The CSA have not published specific amendments but are seeking comment on possible changes to NI 81-104 to create a framework for investment funds that focus on alternative asset classes or use alternative investment strategies. NI 81-104 currently exempts commodity pools (mutual funds that have adopted fundamental investment objectives that permit them to use or invest in specified derivatives or physical commodities in a manner that is not permitted by NI 81-102) from certain investment and operational restrictions of NI 81-102. The CSA also propose to replace the term "commodity pool" with "alternative fund". Although the structure of such an alternative fund framework remains unclear, the CSA seek feedback on several aspects of proposed amendments of NI 81-104, including:
- permitting flexibility for an alternative fund with respect to
the concentration restrictions of NI 81-102;
- allowing investments by alternative funds in physical
commodities and specified derivatives;
- permitting fund-of-fund structures where the underlying funds
are reporting issuers in the same jurisdiction as the alternative
- permitting cash borrowing by alternative funds of up to 50% of
the fund's net asset value;
- permitting short sales where short exposure to any one issuer
is capped at 10% of an alternative fund's net asset value and
aggregate short exposure is capped at 40% of the fund's net
- exempting an alternative fund from the cash cover requirements
of NI 81-102;
- applying the current exemptions in NI 81-104 relating to the
creation of leverage through specified derivatives to alternative
- repealing an existing exemption contained in NI 81-104 relating
to counterparty credit exposure, the repeal of which would restrict
an alternative fund from having a mark-to-market exposure under its
specified derivatives positions with any one counterparty that is
not an acceptable clearing corporation exceeding 10% of the
fund's net asset value for a period of 30 days or more;
- the introduction of a total leverage limit for alternative funds of 3:1, based on the leverage calculation method currently specified in Form 41-101F2.
The alternative fund proposals also include disclosure requirements, such as mandating the use of the words "alternative fund" in the fund name, prescribing certain disclosure (bold and in a text box) on prospectus face pages and in marketing communications, and requiring enhanced continuous disclosure with respect to the use of leverage. The CSA are also considering increasing the seed capital requirements applicable to the launch of a new fund. Finally, they are considering the proficiency requirements that should apply to sales representatives selling alternative fund securities.
Timing and next steps
The CSA note that certain aspects of the proposals, particularly operational requirements such as those related to conflicts of interest, custodianship and securityholder and regulatory approval provisions, would be finalized in advance of other aspects such as proposed investment restrictions (which will be considered in conjunction with the implementation of the alternative fund framework and will likely come into force at a later date). Once finalized and brought into force, the following transition periods are proposed by the CSA:
- an 18-month transition period for existing closed-end funds to
comply with the new investment restrictions, while new closed-end
funds would have to comply immediately upon inception;
- an 18-month transition period for compliance with the
performance fee provisions of Part 7 of NI 81-102; and
- a six-month transition period for existing closed-end funds to comply with the sales communications provisions of Part 15 of NI 81-102.
In "stage two" of Phase 2 of the Modernization Project, the CSA will review the investment restrictions applicable to mutual funds to determine whether changes may be required in light of market and product developments.
The deadline for submitting comments to the CSA is June 25, 2013. Please contact a member of our Investment Funds & Asset Management Group listed below if you have any questions or seek assistance with the preparation of a comment letter.
This is the first of a series of bulletins and updates dealing
with the CSA Modernization of Investment Fund Product Regulation
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
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