The Ontario Securities Commission (OSC) recently granted technical relief to providers of exchange traded funds (ETFs) in Canada, and to their dealers, that is conditional on the filing of prescribed summary disclosure documents and delivery of these documents to investors in ETFs. The series of OSC decisions reinforce the OSC's commitment to ensure that investors in all publicly offered investment funds have access to effective and meaningful disclosure through a largely harmonized summary disclosure document – Fund Facts documents for mutual funds and summary documents for ETFs. The key condition to the OSC's relief is that each ETF must file, prior to September 1, 2013, and thereafter concurrently with its final prospectus or an amendment to its prospectus, and post on its website, a prescribed summary disclosure document for each class or series of securities of the ETF. The summary document must be provided to certain dealers upon reasonable request.
The OSC's exemptions also permit the registered dealers and discount brokers acting on a trade of an ETF to deliver the latest summary document of the ETF to an investor in full satisfaction of the post-trade prospectus delivery obligations set out in securities legislation. The decisions in favour of the dealers require delivery of the summary document to investors regardless of whether the trade in question constitutes a "distribution" under securities legislation (that is, the resale of 'creation units' to investors trading on an exchange).
The OSC's decisions will expire in two years – on September 1, 2015 – which is intended to give the Canadian securities regulators enough time to codify the new summary disclosure requirements for ETFs, as well as the prospectus delivery requirements, as part of the overall CSA point of sale disclosure initiative1.
The OSC's decisions are consistent with the disclosure principles for ETFs set out in the final report Principles for the Regulation of Exchange Traded Funds which was released by the Board of the International Organization of Securities Commissions (IOSCO) in late June 2013 [available here]. The Final Report was prepared by the IOSCO Committee on Investment Management and identifies a set of nine principles intended to influence the regulation of ETFs by member regulators and promote industry best practices. The IOSCO Committee, on which both the OSC and Québec's Authorité des marchés financiers (AMF) have staff members, acknowledges the variety of exchange-traded products available in the market, but explains that the Final Report is limited to exchange traded funds that are organized as collective investment schemes (CIS), commonly known as ETFs.
IOSCO's nine principles for the regulation of ETFs are grouped into two parts:
1. Principles Relating to ETF Classification and Disclosure
2. Principles Relating to the Structuring of ETFs
CLASSIFICATION AND DISCLOSURE
The majority of the IOSCO principles focus on ETF classification and disclosure. Given the increased interest in ETFs worldwide and as ETF strategies have become more complex and innovative, IOSCO suggests that steps must be taken to address possible investor confusion and to clearly identify possible investment risks. Generally, IOSCO believes that ETF providers should focus on disclosure of (i) the risks and benefits of an investment in an ETF versus an investment in another type of collective investment product (such as disclosure explaining the peculiarities of the unit creation/redemption mechanism or the factors that affect intraday liquidity), (ii) the portfolio securities held by an ETF, (iii) the costs and expenses associated with investing in an ETF and (iv) the different strategies that may be used by ETFs (such as full replication, sampling, leveraged, inverse and other synthetic strategies) including meaningful information about the ETF's anticipated use of derivatives in light of actual or anticipated operations. To address these points, the Final Report outlines the following principles:
Regulators should encourage disclosure that helps investors to clearly differentiate ETFs from other exchange-traded products.
Regulators should seek to ensure a clear differentiation between ETFs and other CIS, as well as appropriate disclosure for index-based and non index-based ETFs.
Regulators should require appropriate disclosure with respect to the manner in which an index-based ETF will track the index it references.
Regulators should consider imposing requirements regarding the transparency of an ETF's portfolio and/or other appropriate measures in order to provide adequate information concerning:
i) any index referenced and its composition; and
ii) the operation of performance tracking.
Regulators should encourage the disclosure of fees and expenses for investing in ETFs in a way that allows investors to make informed decisions about whether they wish to invest in an ETF and thereby accept a particular level of costs.
Regulators should encourage disclosure requirements that would enhance the transparency of information available with respect to the material lending and borrowing of securities (e.g., on related costs).
Regulators should encourage all ETFs, in particular those that use or intend to use more complex investment strategies, to assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner and whether it addresses the nature of risks associated with the ETFs' strategies.
STRUCTURING OF ETFS
The second part of the Final Report addresses the conflicts of interest that may arise between an ETF manufacturer and an ETF investor. Possible conflict of interest situations include affiliated index providers, securities lending agents, designated brokers or authorized participants and derivative counterparties. IOSCO focuses on synthetic ETFs and, in particular, the adequacy of risk disclosure with respect to counterparty exposure, collateral management and securities lending. IOSCO identifies two principles to help to address these issues:
Regulators should assess whether the securities laws and applicable rules of securities exchanges within their jurisdiction appropriately address potential conflicts of interests raised by ETFs.
Regulators should consider imposing requirements to ensure that ETFs appropriately address risks raised by counterparty exposure and collateral management.
In addition to the principles set out above that address aspects specific to ETFs, IOSCO examined broader market stability issues and makes general recommendations in the Final Report. These broader issues include intermediaries' disclosure obligations and conduct requirements, including the importance of intermediaries assessing the suitability of ETFs for investors, as well as the risk of abusive behavior and the impact of that behavior on market integrity.
IOSCO's Final Report was derived from the consultation feedback that the IOSCO Committee on Investment Management received regarding its Consultation Paper entitled Principles for the Regulation of Exchange Traded Funds published for comment on March 14, 20122. The Consultation Paper proposed a set of 15 "investor protection" principles or best practices for ETF regulation. The majority of these proposed principles remain in the Final Report. However, principles relating to the role of intermediaries in the marketing and sale of ETFs and relating to the risks arising on secondary markets (risk of shock transmission) were eliminated from the final set of principles primarily because these concerns were considered by IOSCO to be applicable generally to all complex financial products.
Given the involvement of staff of the OSC and the AMF on the IOSCO Committee on Investment Management, together with the CSA's interest in harmonizing the regulation of all publicly offered investment funds and their overall commitment
to fostering IOSCO principles in Canadian securities regulation, we expect that the CSA will consider the principles set out in the Final Report as part of the CSA's ongoing modernization project on the rules relating to mutual funds and other investment funds3, as well as their point of sale disclosure project.
1 See Canadian Securities Regulators Finalize New Format for Fund Facts and Mandate Delivery Effective June 13, 2014 Investment Management Bulletin June 2013 Borden Ladner Gervais LLP [ available here].
2 For more information on the Consultation Paper, please see IOSCO Releases Consultation Paper – Principles for the Regulation of Exchange Traded Funds Investment Management Bulletin March 2012 Borden Ladner Gervais LLP [ available here].
3 Please see the following Investment Management Bulletins at the links provided:
Canadian Regulators Propose to Modernize Investment Fund Regulation Investment Management Bulletin June 2011 Borden Ladner Gervais LLP [ available here]. Updated Mutual Funds Rules finalized in Canada for ETFs, Money Market Funds, Short Selling and Fund of Funds Investment Management Bulletin February 2012 Borden Ladner Gervais LLP [ available here].
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