On March 27, 2013, the Canadian Securities Administrators (CSA) published proposed rule amendments designed to fulfil Phase 2 of the CSA's project to modernize investment funds – a project first announced in May 2011. Proposed amendments to National Instrument 81-102 Mutual Funds [available here] transform NI 81-102 – to be renamed Investment Funds – into a rule to regulate publicly offered "investment funds" by introducing core operational requirements and investment restrictions for closed-end funds that mirror rules that apply to mutual funds. In addition, the CSA signalled their willingness to consider a separate regime for publicly offered "alternative funds", which would be mutual funds and closed-end funds to which NI 81-102 applies, but which would have greater flexibility to invest in alternative asset classes or use alternative investment strategies. The CSA's framework for alternative funds will be achieved through a "redesign" of National Instrument 81-104 Commodity Pools. The CSA published only a framework outlining their initial considerations for comment; no actual proposed amendments to NI 81-104 were published. Other proposed amendments to NI 81-102 include amendments to the existing requirements relating to securities lending, repurchase and reverse repurchase transactions.
The proposed rule amendments should be carefully considered, given their potential effect on current and future closed-end funds.
CSA MODERNIZATION PROJECT FOR INVESTMENT FUNDS
We described the CSA's overall modernization project for investment funds in our June 2011 Investment Management Bulletin Canadian Regulators Propose to Modernize Investment Fund Regulation [available here]. Phase 1 of the CSA's modernization project was completed on April 30, 2012, when various updated mutual fund rules set out in NI 81-102 came into force (new money market fund rules were effective on October 30, 2012). The current proposed amendments to NI 81-102 represent the first stage of Phase 2 of the CSA's modernization project.
In the second stage of Phase 2, the CSA will review the investment restrictions applicable to mutual funds in Part 2 of NI 81-102 to assess if any changes should be made in light of market and product developments. The CSA have not indicated any time frame for this work.
The deadline for providing comments on the current proposals is June 25, 2013. We are pleased to assist you in providing comments.
PROPOSALS FOR CLOSED-END FUNDS
The CSA propose to expand the application of NI 81-102 to publicly offered "non-redeemable investment funds", so that all types of public investment funds (other than scholarship plans or Group RESPs) are subject to the same rules. Although not enshrined in the proposed regulatory instruments, the CSA confirm, but request feedback on current common understanding that investment funds with an annual redemption right are not "mutual funds" within the meaning of applicable securities laws, but rather are non-redeemable investment funds.
If adopted in their current form, the proposed rule changes will significantly impact the structuring and offerings of closed-end funds, notwithstanding the CSA's stated belief that most of the proposals simply codify current industry practice. It remains to be seen whether these proposed changes will have the unintended consequence of limiting the use of closed-end funds as retail investment vehicles.
Investment Restrictions. The CSA propose that closed-end funds should be subject to most of the investment restrictions currently applicable to mutual funds, as set out in Part 2 of NI 81-102, in some cases with different thresholds. For example, the CSA propose that closed-end funds be permitted to:
- Invest in physical commodities and specified derivatives the underlying interests of which are physical commodities up to a maximum of 10 percent of the fund's net asset value (NAV). Although comparable relief has been granted by the CSA to mutual funds in limited circumstances, the CSA does not propose to allow mutual funds this flexibility – at least by rule change.
- Invest a larger portion of their assets in illiquid assets than is permitted for mutual funds – although this is not reflected in the proposed rule amendments.
- Borrow cash up to an amount equal to 30 percent of the fund's NAV.
- Invest up to 100 percent of the fund's NAV in "guaranteed mortgages" (as defined in NI 81-102). A closed-end fund cannot invest in other types of mortgages.
Otherwise, the investment restrictions applicable to mutual funds would also apply to closed-end funds, including:
- Restrictions on closed-end funds acquiring securities of a mutual fund or another closed-end fund. We note that the proposed amendments also affect mutual funds, as the "fund of fund" rules will prohibit mutual funds from investing in closed-end funds unless all of the conditions are adhered to. Mutual funds and closed-end funds will be prohibited from investing in a "commodity pool" regulated by NI 81-104.
- The 10 percent concentration restriction applicable to mutual funds, although the CSA are considering whether this should be raised to a higher threshold for closed-end funds, given the differences between these funds and mutual funds.
- Restrictions on the use of derivatives.
- Control restrictions. We note that the CSA propose amendments to the Companion Policy to NI 81-102 that clarify their position regarding when an investment fund would be considered to have control over, or be involved in the management, of an investee company. We consider these Companion Policy amendments to be a significant change in regulatory policy that could unjustifiably transform some investment funds into non-investment fund issuers.
- Restrictions on short selling securities.
Seed Capital and Organizational Costs for New Funds. Given that closed-end funds typically raise capital by issuing a fixed number of securities in their initial public offering, unlike mutual funds that distribute their securities on a continuous basis, the seed capital and minimum subscription requirements in NI 81-102 would not apply to closed-end funds. However, the CSA propose that the prohibition on a new mutual fund bearing the costs of its organization be extended to closed-end funds. The CSA acknowledge that this proposed prohibition is contrary to current industry practice and seek comment on the potential impact of such prohibition. The CSA are considering whether the different capital raising model of closed-end funds justifies having the fund pay some of the organization costs and, if so, what specific components of organizational costs should be borne by the fund. There is no specific discussion by the CSA of the ability of a fund to bear the fees of any underwriters, which should be clarified, in our view.
Conflicts of Interest. The prohibition on certain transactions between related parties in Part 4 of NI 81-102 would extend to closed-end funds.
Fundamental Changes. The requirements in Part 5 of NI 81-102 relating to changes that require regulatory and/or investor approval (or notice, in some cases) would be extended to closed-end funds. The CSA also propose that investor approval must be obtained before a fund changes its nature (i.e., from a mutual fund to a closed-end fund or vice versa, or from an investment fund to a non-investment fund issuer). However, a closed-end fund that is structured from inception to convert to a mutual fund at some future time, would be exempt from this requirement provided that certain conditions are met.
Mergers and terminations. The requirements relating to mergers and terminations of mutual funds would apply, without variation, to closed-end funds. However, mergers of investment funds that involve "limited life funds" the securities of which are not listed or traded on an exchange, such as flow-through limited partnerships, will not require investor or regulatory approval as long as certain conditions are met. For a closed-end fund merger to be exempt from the approval requirements, the merging closed-end fund must allow investors to redeem their securities at NAV on a date that is before the merger and it must implement the merger at NAV.
Closed-end funds that wish to terminate must file a press release at least 15 days and no more than 30 days before the date of termination.
Custodianship Requirements. The custodianship provisions in NI 81-102 would be re-drafted to include closed-end funds. As these provisions are essentially the same as the current custodial requirements in National Instrument 41-101 Prospectus Requirements, this does not really represent a change for closed-end funds.
Subscriptions, Redemptions and Warrant Offerings. The CSA propose that many of the provisions in NI 81-102 relating to subscriptions and redemptions of mutual funds will not apply to closed-end funds, as their distribution and redemption models are different from those of mutual funds. However, the CSA propose new provisions for closed-end funds that will prevent dilutive issuances and the mutual fund "redemption rules" would apply to the annual redemptions based on NAV that are made available by many closed-end funds.
Significantly, the CSA propose to prohibit warrant offerings (or the offering of any rights or other specified derivatives the underlying interest of which is a security of the investment fund) for closed-end funds.
Other Provisions. The CSA propose that the provisions relating to incentive fees, commingling of cash, sales communications, setting record dates and investor records in NI 81-102 be extended to closed-end funds, subject to minor modifications to reflect the differences between mutual funds and closed-end funds.
ADDITIONAL PROPOSALS FOR ALL PUBLICLY OFFERED INVESTMENT FUNDS
A few other proposed amendments to NI 81-102 will have an impact on all types of investment funds – mutual funds and closed-end funds.
- Naming Conventions. The CSA seek comment on whether to require investment funds that are subject only to NI 81-102 to have certain identifiers in their name that would identify them as investment funds that use the conventional investment strategies (as opposed to alternative strategies) as permitted in NI 81-102.
- Securities Lending, Repurchase and Reverse Repurchase Transactions. The CSA propose rule changes intended to enhance the transparency of the benefits, costs and risks of securities lending, repurchase and reverse repurchase transactions engaged in by investment funds and seek feedback on certain issues identified by the CSA. The driving force for this development, according to the CSA, is that it is common practice for the agents in these transactions to be compensated by receiving a share of the revenue generated from these transactions. The CSA consider that it is important for investors to understand the returns from these transactions, and how such revenue has contributed to the performance of the investment funds, and to be aware of the costs, profitability and the scope of an investment fund's activities in engaging in these transactions. Accordingly, the CSA propose requiring additional disclosure relating to costs, revenue and returns, among other things, in a fund's offering and continuous disclosure documents if the fund engages in these types of transactions.
PROPOSED FRAMEWORK FOR ALTERNATIVE FUNDS
The CSA's proposed framework for a new category of investment funds, which would be known as "alternative funds", will be accomplished through a redesign of NI 81-104. No proposed rule amendments have yet been published for comment – the CSA seek comment on the proposed framework at this point in their work.
NI 81-104 became effective in November 2002 and was a "reformulation" of an earlier Ontario Securities Commission policy statement on commodity pools, which had been effective since the mid-1980s. In comparison to the large numbers of closed-end funds and mutual funds, very few "commodity pools" have been created in reliance on NI 81-104, which make us question the efficacy of some of the strict and somewhat onerous conditions in NI 81-104, many of which will be retained and/or enhanced under the CSA's proposed framework for alternative funds.
The term "alternative fund" will replace the term "commodity pool" used in NI 81-104. Alternative funds will include both mutual funds and closed-end funds that are otherwise subject to the proposed amended NI 81-102, but will be permitted to invest in alternative asset classes or use alternative investment strategies. The alternative strategies would be permitted so long as the conditions set out in a modified NI 81-104 are complied with.
The following conditions are part of the CSA's proposed framework for alternative funds, some of which are more restrictive than currently set out in NI 81-104, while others provide more flexibility.
Investment Restrictions. The following investment restrictions are being considered by the CSA for alternative funds:
- Concentration restrictions – which may be greater than the current 10 percent threshold for mutual funds and commodity pools (and as proposed for closed-end funds).
- Borrowing restrictions – which may be more flexible than the proposed 30 percent limit for closed-end funds – and considerably more flexible than currently in place for mutual funds and commodity pools.
- Short selling restrictions, but with some additional flexibility to allow for long/ short strategies.
- Restrictions on the use of derivatives relating to counterparty exposure and leverage, both of which would be new restrictions for commodity pools. The CSA are considering restricting alternative funds from providing returns of more than two times the existing daily positive or inverse return of an underlying interest, and setting a total leverage limit for alternative funds of 3:1 to be observed by the fund at all times.
- Restrictions on investing in underlying funds that are not reporting issuers – this restriction applies currently to commodity pools.
New Alternative Funds. The CSA are considering adopting similar requirements as those in NI 81-102 for alternative funds; however, an alternative fund will be required to have received $5 million (instead of $500,000) from "outside investors" (those that are not eligible to provide seed capital to the fund) before the fund is permitted to redeem a security that was issued in exchange for seed capital. It is contemplated that the amount of required seed capital for an alternative fund would be $150,000, the same amount required in NI 81-102, instead of the $50,000 that is currently required for commodity pools in NI 81-104. New alternative funds that are closed-end funds will have to comply with the restriction in the proposed amended NI 81-102 relating to organizational costs.
On-going Investment by Sponsors. While currently NI 81-104 restricts a commodity pool from redeeming securities unless the securities issued to sponsors remain outstanding and the sponsors maintain a $50,000 investment in the commodity pool, exemptive relief has been granted to permit sponsors of a commodity pool to withdraw their seed capital in the commodity pool provided that the commodity pool has received $5 million in subscriptions from "outside investors" and that the sponsors reinvest the seed capital amount if the value of the commodity pool securities subscribed to by outside investors drops below $5 million for more than 30 consecutive days. The CSA are considering codifying this exemption, together with the conditions.
Disclosure. The CSA propose to retain the "long-form" prospectus requirement applicable to commodity pools – that is, requiring alternative funds to prepare a prospectus in accordance with Form F2 in NI 41-101. Enhanced disclosure for alternative funds is also proposed:
- All alternative funds will have the term "alternative fund" in their names, so as to distinguish them from more conventional mutual funds and closed-end funds.
- Prescribed disclosure in the alternative fund's prospectus and sales communications.
- More frequent financial reporting and disclosure of how specific investment strategies have affected the returns of an alternative fund.
- Website postings of an alternative fund's largest monthly and annual NAV drawdowns in the past five years (or since inception for a fund that is less than five years old).
- Monthly reports on the fund's website of its maximum and average daily leverage amounts during the most recent 12 month period.
- Disclosure of an alternative fund's use of investment strategies that create leverage in the fund's semi-annual and annual disclosure documents.
Dealer Proficiency. The CSA are considering whether to impose additional proficiency requirements on dealing representatives who trade in securities of alternative funds for clients, although no concrete proposals are made. Additional proficiency requirements currently apply to trades in commodity pools and have a particular impact on dealing representatives, and their supervisors, of mutual fund dealers that are members of the Mutual Fund Dealers Association of Canada (MFDA).
Publication of the CSA's proposals to affect Phase 2 of their investment fund modernization project represents a major milestone for the CSA. It remains to be seen whether their proposals will have a negative or positive effect on the investment fund industry – and also on fund managers wishing to provide alternative strategy funds to their investors.
This public consultation is a great opportunity to help shape future regulation. We would be pleased to discuss any aspect of the CSA's proposals with you and assist you in preparing your comments to the CSA.
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.