CSA proposes operational requirements and prohibition on paying organizational costs for closed-end funds
This is the fourth in a series of McMillan bulletins relating to the Canadian Securities Administrators project to modernize the regulation of publicly offered investment funds. The bulletins separately address how the modernization project affects different types of investment fund products. Previous bulletins focused on changes affecting open-end mutual funds and proposed investment restrictions for non-redeemable investment funds (closed-end funds or CEFs). This bulletin will focus on proposed operational requirements for closed-end funds. A future bulletin will focus on proposed changes to establish a regime for "alternative funds" that will encompass both mutual funds and CEFs that employ alternative investment strategies.
On March 27, 2013 the Canadian Securities Administrators (CSA) published for a 90-day comment period proposed changes to the regulatory regime governing investment funds pursuant to Phase 2 of its Modernization of Investment Fund Product Regulation Project (the Modernization Project).
In this installment in our series of bulletins on the Modernization Project, we summarize and discuss the expected impact of operational requirements proposed to be applied to CEFs. The CSA propose to introduce core operational requirements to CEFs similar to those that apply to mutual funds under National Instrument 81-102 Mutual Funds (NI 81-102). In the CSA's view, these requirements provide baseline protections to investors that purchase investment fund products that should not be limited to mutual funds.
Prohibiting CEFs from bearing organizational expenses – a blow to the industry?
Currently, NI 81-102 prohibits the organizational costs of a mutual fund to be borne by either the mutual fund or its securityholders. These include costs associated with the formation of the mutual fund as well as the preparation and filing of a prospectus and related documents. The proposed Phase 2 amendments include a prohibition on CEFs or its securityholders from bearing organizational costs, which would be a significant departure from market practice of having the CEF pay organizational costs from the proceeds of its initial public offering (IPO).
We note that this proposal was not mentioned in the CSA's status report on the implementation of the Modernization Project published in 20111 and we expect it to generate a great deal of debate in the CEF industry.
One of the stated purposes of this proposal is to align the interests of managers and investors by shifting the financial risk associated with the launch of a CEF from the investors to the manager on the basis that both groups benefit from establishing sustainable CEFs. Another stated benefit of this proposal is increased cost efficiency on the theory that if fund managers are required to bear the organizational costs, it would somehow reduce the overall cost of launching a new fund. The CSA also note that this proposal may discourage regulatory arbitrage. The example provided is the launch of a CEF with a planned conversion to a open-end mutual fund after a period of time (e.g. 12 to 24 months), although this doesn't appear to be a significant segment of the market.
While the stated objective of this proposal is to level the regulatory playing field between mutual fund and CEF managers, the market practice of CEFs paying organizational costs reflects the fundamental differences between these products. Notably, as CEFs are exchange listed products that are offered through a syndicate of investment dealers, the associated costs of launching a CEF are significantly higher when compared to the launch of a mutual fund. Some of the additional expenses incurred by new CEFs include the preparation of a long-form prospectus, dealers' legal fees and listing fees. In comparison, the costs of forming a new mutual fund and preparing a simplified prospectus and annual information form are generally a fraction of the costs of a new CEF (in the simplest example, a new mutual fund can be launched by an amendment to an existing simplified prospectus). Also notable is that while mutual fund managers bear the organizational costs of launching new funds, they generally recover their costs from investors over time through deferred sales charges (and potentially higher management fees). Another fundamental difference between CEFs and mutual funds is that CEFs are usually distributed in a single offering, meaning that investors are on an equal footing and no particular group of purchasers is prejudiced by the fund paying the offering expenses from its IPO proceeds. In contrast, because mutual funds are in continuous distribution, the prohibition on bearing organizational costs prevents the burden from falling solely on the initial investors.
If the changes as proposed were implemented, it would likely reduce the number of CEFs brought to market. The CSA have stated that both investors and managers benefit from the introduction of new funds. It is unlikely that investors would have an alternative means to access the strategies offered by innovative CEF products without the associated cost (which could be substantial if an investor tried to replicate a CEF's investment strategy on their own).
CEF managers already face financial risk in several ways. CEF managers are already ultimately responsible for the organizational expenses in the event of a failed transaction. In addition, the general industry practice imposed by the dealer syndicate that offering expenses borne by a CEF should be capped at 1.5% of gross proceeds of the IPO means that managers bear any additional costs themselves.
The CSA recognize that the proposed change would impact the ability of smaller managers to launch new CEFs and that not all managers would be able to independently finance organizational costs. With this in mind, the CSA seek comments on whether the capital raising model used by CEFs may support the fund paying some of the organizational costs and whether specific components of organizational costs might be appropriately allocated between the fund and the manager. The CSA have asked for information about the relevant cost components regarding the launch of a CEF, the fraction of each component that would typically constitute the total organizational costs and the reasons why it would be appropriate for either the fund or the manager to bear specific costs.
We should also note that currently exchange-traded funds that are not in continuous distribution have an exemption from the prohibition on bearing the organizational costs of the fund. However, the proposed amendments purport to eliminate this exemption going forward.
Custodianship requirements – no controversy here
The CSA propose to extend the custodianship requirements of NI 81-102 to CEFs. This may be seen as a non-controversial proposition, as these provisions are for the most part the same as the current requirements applicable to CEFs that file a prospectus under National Instrument 41-101 Prospectus Requirements (NI 41-101). The proposed changes to the custodial requirements of NI 81-102 are non-substantive and it is simply intended that there be one set of rules governing both mutual funds and CEFs. The CSA are not asking any specific questions on this proposal. Most commenters responding to Staff Notice 81-322 agreed that the segregation and security of fund assets is obligatory and that it makes sense to have these requirements in one operational rule (the current location of CEF custodial rules in NI 41-101, which relates to prospectus content, might be confusing in any event). The CSA point out that one commenter suggested that the custodial rules be amended to allow the deposit of assets with prime brokers instead of only custodians, and to permit funds to access a broader universe of custodians beyond Canadian financial institutions, comments that have not influenced the CSA's approach.
No conflict with conflicts of interest requirements
Another proposed change is to extend the conflicts of interest provisions of NI 81-102 to CEFs, a proposal that was broadly supported by commenters in response to Staff Notice 81-322. Some commenters expressed concerns regarding the inherent complexity of the multiple conflict of interest rules (contained in NI 81-102, National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, National Instrument 81-107 Independent Review Committee for Investment Funds (NI 81-107) and provincial securities statutes), and the fact that certain conflicts of interest prohibitions in NI 81-102 already apply to CEFs through other legislation. One commenter expressed concerns with the independent review committee model of NI 81-107 in dealing with conflict of interest matters generally since the onus to identify conflicts rests with the manager. The CSA stated that they will consider rationalizing the conflicts of interest regime in the context of future amendments to NI 81-107 and any required amendments to the conflict of interest provisions of NI 81-102 in the next phase of the Modernization Project. The CSA are not asking any specific questions on this proposal.
Fundamental changes not fundamentally troubling
The CSA propose to extend the provisions of NI 81-102 relating to fundamental changes to CEFs. These requirements include detailed rules regarding matters that require securityholder approval, the process to obtain such approval (including the mechanics surrounding securityholder meetings) and circumstances in which the approval of securities regulators is required. While many CEFs already adhere to investor voting rights that are similar to those in NI 81-102 in their constating documents, the CSA view that codification of these requirements will provide investors with consistent and guaranteed voting rights regarding important changes. One commenter to Staff Notice 81-322 expressed the view that CEFs should not be required to obtain regulatory approval of fundamental changes if they have received securityholder approval, while another commenter felt that prior regulatory approval should be required for all significant transactions. Calls for revisions in either direction do not appear to have impacted the CSA's analysis, as they do not currently propose any amendments to the regulatory approval requirements in NI 81-102.
The CSA also propose to mandate investor approval for a fund to convert from a CEF to a mutual fund or vice versa, or for the conversion of an investment fund into an issuer that is not an investment fund. The costs and expenses associated with such a merger, reorganization or restructuring (including the costs of obtaining securityholder approval and, if applicable, the costs of filing a simplified prospectus to commence a continuous distribution) may not be borne by the fund. The CSA take the view that since reorganizations and restructurings permit managers to retain a fund's assets under management, such transactions are beneficial to managers and managers should therefore bear the associated costs. CEFs that are structured from inception to convert to a mutual fund would be exempt from the securityholder approval requirements provided that certain conditions are met with respect to sales communication disclosure of the conversion and securityholder notice prior to the conversion. The CSA also propose to exempt specialized non-redeemable funds that have a limited life and that do not list or trade their securities on a secondary market from requiring securityholder and regulatory approval for a merger. Such funds, typically "flow-through" limited partnerships, would be allowed to effect a rollover into a mutual fund without securityholder and regulatory approval if other certain requirements, such as prospectus disclosure requirements, are met.
Another new requirement proposed by the CSA is that the consideration offered to securityholders of a CEF in connection with a merger of the fund that is effected without prior securities regulatory approval must have a value that is equal to the net asset value of the fund. Managers should keep this new requirement in mind if mergers are intended to be effected in reliance on the exemption from prior securities regulatory approval contained in section 5.6 of NI 81-102.
Finally, the CSA proposals would require CEFs to terminate the fund not less than 15 days before and not more than 30 days after disclosing an intended termination.
The CSA do not seek specific comments on these proposals concerning fundamental changes.
NI 81-102 sets out parameters for the payment of incentive fees by a mutual fund, which the CSA propose to extend to CEFs. Specifically, performance fees would be required to be determined with reference to an external benchmark or index that reflects the market sector in which the CEF invests. This proposed change might prove controversial as the performance fees paid to managers by many CEFs are based on the internal cumulative total returns of the fund rather than a benchmark. One commenter to Staff Notice 81-322 expressed the view that the incentive fee requirements of NI 81-102 should not apply to CEFs as flexibility with respect to fee arrangements may encourage product innovation. We also note that the common CEF practice of making performance fees payable only with respect to positive returns of the fund (and often only with respect to returns above a certain hurdle rate) could be seen as preferable by some investors to basing fees on outperforming an external benchmark or index which may itself be performing poorly. However, the CSA expressed the view that the incentive fee provisions of NI 81-102 represent a fair basis for determining such fees. They also note their proposed intention to develop a regime for "alternative funds" that could permit a wider range of incentive fee arrangements for funds that use alternative investment strategies.
Commingling of cash
The CSA propose to extend the requirements of NI 81-102 relating to the commingling of cash to CEFs. These provisions require dealers or service providers in relation to an investment fund to segregate cash received in respect of purchases or redemptions of securities in a trust account. One commenter to Staff Notice 81-322 noted that investment dealers who distribute and hold securities of CEFs for their clients are already subject to substantially similar requirements under the Investment Industry Regulatory Organization of Canada (IIROC) rules and the NI 81-102 requirements should therefore not be adopted for CEFs. The CSA's response is that the requirements apply to other service providers and not only to IIROC dealers and that there is no policy rationale to exclude CEFs from the ambit of these rules. The requirements would seem ultimately non-controversial and the CSA do not seek specific comments.
Just saying no to dilution – prohibiting warrant offerings
Another proposed amendment would prohibit warrant offerings or the offering of any rights or other specified derivatives where the underlying interest is a security of the fund. The CSA view such offerings as being dilutive to the value of the securities held by investors who do not exercise such warrants and propose this prohibition in response to the issuance of warrants by some CEFs in recent years. The CSA also view the issuance of warrants as coercive by obligating securityholders to exercise and make an additional investment or face the risk of dilution. We do not expect this proposal to generate significant controversy and the CSA do not seek specific comment on this point, though it would close off an avenue to grow the fund for CEFs that, unlike mutual funds, are not in continuous distribution.
Additional anti-dilution provisions are being proposed as well, which will require that the issue price of securities of CEFs (and exchange-traded funds that are not in continuous distribution) must not be a price that is less than the net asset value per security determined on the date of issuance. Also, if such a fund issues securities under a prospectus, the issue price of each such security must not be a price that causes dilution of the net asset value of other outstanding securities of the fund and must not be at a price that is less than the net asset value per security of that class, or series of that class, determined on the date that is one business day before the date of the prospectus. The CSA invite comment on whether these proposed amendments achieve the purpose of preventing dilutive issuances.
The requirements of NI 81-102 governing sales communications would be extended to CEFs under the CSA proposals. These are guidelines designed to ensure that disclosure for investment funds is relevant, consistent and not misleading. A significant portion of the requirements relate to the use and calculation of performance data, which must be based on actual historical performance and not on hypothetical or back-tested data. Under the proposed amendments, a sales communication pertaining to a CEF must not contain performance data of the fund unless the fund has been a reporting issuer in a jurisdiction for at least 12 consecutive months and may not contain performance data from before the fund became a reporting issuer. An advertisement for a CEF must not compare the performance of the CEF with any benchmark or investment other than (i) funds that are under common management with the CEF in question, (ii) funds that have similar investment objectives or (iii) an index. The CSA propose to allow a mutual fund that has been converted from a CEF to use past performance data from the period when it existed as a CEF, which is consistent with exemptive relief that has been granted to such funds in the past. While we do not expect the extension of the sales communications requirements to be a contentious issue, managers of CEFs must be cognizant of these detailed rules and the fact that compliance with these rules is closely monitored by securities regulators.
Recognizing the differences between mutual funds and CEFs, the CSA only propose to extend a few of the provisions relating to redemptions of NI 81-102 to CEFs. CEFs that offer annual redemptions based on NAV (or more frequent redemptions at market value) will be required to send investors an annual reminder regarding their redemption rights and how they may be exercised. To facilitate the timely processing of redemptions, proceeds would have to be paid no more than 15 business days after the redemption date. To avoid dilution to remaining securityholders, the proposed amendments would prohibit CEFs from redeeming securities at an amount that is greater than NAV per security on the redemption date.
In addition, CEFs would only be permitted to suspend redemptions if trading is suspended on an exchange, if the securities or specified derivatives listed or traded on such exchange represent more than 50% of the total assets or underlying market exposure of the CEF and no other exchange that represents a reasonably practical alternative. In the case of a clone fund, the CEF would also be able to suspend redemptions if the fund whose performance it tracks has suspended redemptions. As a practical matter, many CEFs have adopted similar provisions in their constating documents.
To promote transparency, the CSA also propose to amend the prospectus disclosure requirements applicable to CEFs in Form 41-101F2 to require disclosure of the amount, or maximum amount or percentage that may be deducted from the NAV per security in calculating proceeds payable upon redemption.
The CSA seek comment on whether they should reconsider their current (and historical) position that CEFs that offer annual redemptions based on NAV should be considered to be "non-redeemable investment funds" and not mutual funds, and instead think about whether any investment fund that offers redemptions based on NAV should be considered a mutual fund for purposes of the regulatory regime. Because the ability to offer annual redemptions at NAV is an important operational tool for CEFs that is non-prejudicial to securityholders, there would not appear to be any substantive reasons to reconsider the traditional approach.
Transition period – no grandfathering?
The proposed amendments do not include a grandfathering provision with respect to the application of the proposed changes to existing CEFs. Instead, the CSA has proposed an 18-month transition period for existing CEFs to comply with the new investment restrictions, an 18-month transition period for compliance with the proposed performance fee provisions, and a six-month transition period to comply with the proposed sales communications provisions. However, the CSA invite comments as to whether a grandfathering provision is warranted for existing CEFs. We note that because of the costs and logistics associated with compliance for existing CEFs, which could be faced with considerations of whether to wind up or convert to another structure, a grandfathering provision would be fair and is likely to be urged by the industry.
The deadline for submitting comments to the CSA on the proposed amendments in Phase 2 is June 25, 2013. Please contact one of the authors of this bulletin listed below or another member of our Investment Funds & Asset Management Group if you have any questions regarding the proposed amendments or seek assistance with the preparation of a comment letter relating to these proposals.
1 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 (Staff Notice 81-322).
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.
© Copyright 2013 McMillan LLP