Canada: A Closer Look At Investment Fund Modernization

The Canadian Securities Administrators recently announced the adoption of final amendments that will implement certain aspects of Phase 2 of the Modernization of Investment Fund Product Regulation Project (the Amendments). As  we discussed in an earlier post, the stated objective of Phase 2 was to achieve fair and consistent product regulation across the spectrum of retail investment funds, by broadly imposing certain "core" operational requirements on all types of publically offered (prospectus qualified) investment funds, whether such funds are traditional mutual funds or non-redeemable investment funds (NRIFs), which include closed-end funds and exchange traded mutual funds.

Subject to Ministerial approval requirements, the Amendments come into force on September 22, 2014. The Amendments, among other things, introduce the imposition of core investment restrictions for non-redeemable investment funds relating to investments for control, investments in real property, investments in non-guaranteed mortgages, investments in loan syndications and investments in other investment funds (fund-on-fund structure), and extend the framework in respect of securities lending, repurchase and reverse repurchase transactions to NRIFs.

Other elements of NI 81-102 that will be extended to, and to a certain extent expanded in relation to, NRIFs include requirements relating to conflicts of interest and securityholder and regulatory approval for fundamental changes. New requirements and restrictions with respect to the issuance of additional securities will also be implemented.

We will discuss some of the key aspects of the Amendments applicable to NRIFs in further detail below, as well as the applicable transition periods and limited grandfathering provided.

Investment Restrictions

Control Restriction

NI 81-102 will restrict all NRIFs that are reporting issuers, including NRIFs, from purchasing a security of an issuer (a) if the fund would hold more than 10% of the votes or outstanding equity of the issuer or (b) for purposes of exercising control over, or management of, the issuer (the Control Restriction). The CSA intend for the Control Restriction to restrict investments by investment funds that the CSA view to be "inconsistent with the fundamental characteristics of investment funds" as passive investment vehicles that are not actively involved in the management of investee companies.

The Control Restriction will apply to all new NRIFs effective September 22, 2014, provided that NRIFs that have filed a prospectus for which a receipt was issued on or before September 22, 2014 (Existing NRIFs) will have a transition period ending March 21, 2016 during which period such NRIFs must take steps to comply with the Control Restriction or seek exemptive relief from the Control Restriction, given that the CSA have not grandfathered existing NRIFs from the Control Restriction.

Investments in Real Property, Loan Syndications and Non-Guaranteed Mortgages

NI 81-102 will restrict NRIFs from investing in real property, mortgages (other than guaranteed mortgages) and loan syndications or participations. According to the CSA, these types of investments are inconsistent with the fundamental characteristics of publicly offered investment funds, including NRIFs. In particular, the CSA view investing in mortgages (other than guaranteed mortgages) as engaging in an active lending business and not as portfolio management activities of an investment fund (this view is consistent with the position taken in OSC Staff Notice 81-722 - Mortgage Investment Entities and Investment Funds).

The above restrictions will apply to all new NRIFs effective September 22, 2014. Existing NRIFs that are reporting issuers will have a transition period ending March 21, 2016, with respect to investments in real property and loan syndications or participations. Existing NRIFs that have adopted "fundamental investment objectives" permitting investments in mortgages are grandfathered from the restriction against investment in non-guaranteed mortgages.

Notwithstanding the grandfathering provision, the CSA will continue to focus on investments in non-guaranteed mortgages in prospectus reviews of any subsequent issuances of securities by Existing NRIFs relying on the grandfathering provision.

Fund-on-Fund Structure

NI 81-102 will permit a NRIF to invest in another investment fund that (a) is subject to NI 81-102 or complies with the provisions of NI 81-102 applicable to NRIFs and (b) is a reporting issuer in a jurisdiction in which the NRIF is a reporting issuer. Mutual funds will not be permitted to invest in NRIFs.

New NRIFs must comply with the fund-on-fund restrictions effective September 22, 2014, while Existing NRIFs will have a transition period ending March 21, 2016. NRIFs that invest in foreign investment funds that would not meet the requirements in NI 81-102 set out above and mutual funds that currently invest in NRIFs will be required to apply for exemptive relief to permit them to continue investing in such underlying funds which the CSA will consider on a case-by-case basis.

Securities Lending, Repurchases and Reverse Repurchases

NI 81-102 will require that NRIFs comply with the framework for securities lending, repurchase and reverse repurchase transactions that previously only applied to mutual funds.

Additionally, the Amendments will introduce new disclosure requirements (Disclosure Requirements) for both mutual funds and NRIFs by way of amendments to NI 81-106, NI 41-101 and NI 81-101. Such disclosure requirements were drafted as a result of comments received on the original draft proposal in respect of Phase 2 published by the CSA in March 2013.

As part of the Disclosure Requirements, investment funds must include a note on the fund's financial statement reconciling the gross amount generated from securities lending transactions to the revenue from securities lending, which is disclosed as a separate line item in the fund's statement of comprehensive income.

Conflicts of Interest

The Amendments extend the conflicts of interest provisions of NI 81-102 to NRIFs. These provisions provide securityholders of NRIFs with key protections with respect to conflicts matters that are consistent with the current practices of most prospectus qualified NRIFs.

Fundamental Changes

The Amendments extend the application of securityholder and regulatory approval requirements to NRIFs. Many of such approvals are consistent with the current practices of most NRIFs, and include securityholder approval for fund mergers, conditions for pre-approved fund mergers and regulatory approval for a change in investment fund manager or a change in control of the investment fund manager.

One change of particular note to investment fund managers is a prohibition against a NRIF bearing the cost and expense to (a) restructure from a NRIF to a mutual fund or to an issuer that is not an investment fund and (b) complete a pre-approved merger transaction. This change is based on the CSA's view that such a conversion or merger isfor the benefit of the investment fund manager and not securityholders of the NRIF.

Flow-through limited partnerships, which are specialized NRIFs that have a limited term and do not trade on an exchange, will be exempt from the securityholder and regulatory approval requirements for mergers provided such funds satisfy certain requirements, including tailored prospectus disclosure relating to such exempt transaction.

NI 81-102 will require that NRIFs terminate no earlier than 15 days and no later than 90 days after the filing of a press release disclosing the intended termination.

Custodianship Requirements

The Amendments extend the custodial requirements in NI 81-102 to NRIFs. As such, the custodial requirements are now applicable to all NRIFs that are reporting issuers rather than only those that have filed a prospectus under Part 14 of NI 41-101.

Sale of Securities

The Amendments prevent a NRIF or an exchange-traded mutual fund that is not in continuous distribution from dilutive issuances of securities. The issue price of a security of a NRIF must not be, as far as reasonably practical, (i) a price that causes dilution to the net asset value of the other outstanding securities of the fund at the time the security is issued, or (ii) a price that is less than the most recently calculated net asset value per security calculated prior to the pricing of the offering. This restriction on dilutive issuances of securities of NRIFs is consistent with current market practice.

Included in the Amendments is additional guidance in section 10.6 of 81-102CP as to how the CSA will interpret the restrictions on the issue price of securities of NRIFs.

Warrant Offerings Prohibited

The Amendments will restrict investment funds from issuing warrants or rights or from entering into a position in a specified derivative, the underlying interest of which is a security of the investment fund. The CSA view the potential harm to securityholders of an investment fund from the dilution caused by the issuance of such securities as outweighing any benefits of such offerings. This is consistent with the OSC's position, as articulated in the  April 2012 edition of the Investment Funds Practitioner.


The Amendments will extend to NRIFs many of the requirements applicable to mutual funds with respect to redemptions. These requirements include (a) sending securityholders an annual reminder regarding redemption procedures, including applicable deadlines and required documentation, (b) a restriction on redeeming securities at a price greater than the net asset value on the redemption date, (c) paying redemption proceeds no later than 15 business days after the redemption date and (d) only permitting the suspension of redemptions in prescribed circumstances.

NRIFs will also be required to include certain disclosure regarding their redemption procedures in their prospectus. Such disclosure must include the amounts that may be deducted from the net asset value per security in connection with the payment of redemption proceeds to redeeming securityholders, a description of such amounts and the entity to which each such amount is paid.

Commingling of Cash

The Amendments will extend the application of Part 11 of NI 81-102 such that the provisions relating to the holding of monies from sales and redemptions of securities will apply to NRIFs. While the Amendments should not impact most NRIF public offerings, for greater certainty, the Amendments contain an exemption from certain of these requirements for CDS Clearing and Depository Services Inc. to facilitate NRIF redemptions that, unlike mutual fund redemptions, are not effected through FundSERV.

Sales Communications

The Amendments will extend the provisions of Part 15 of NI 81-102 to sales communications of NRIFs, with certain modifications to recognize the difference between mutual funds and NRIFs, though may NRIFs currently follow these guidelines as best practice. Further, a mutual fund that was converted from a NRIF will be required to present past performance data for the period when it existed as a NRIF if it wishes to present performance data.

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.

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