Canada: Investment Funds @ Gowlings – July 2006

Last Updated: July 31 2006

Edited by Paul A. Dempsey


  • Proposed Soft Dollar Rule
  • CSA Staff Notice on Principal Protected Notes
  • MFDA Notice on Undivided Interests in Land
  • OSC Staff Notice on LMDs
  • OSC Staff Notice on Model Portfolios

Proposed Soft Dollar Rule

On July 21, 2006 the Canadian Securities Administrators (the "CSA") published for comment proposed National Instrument 23-102 – Use of Client Brokerage Commissions as Payment for Order Execution Services or Research ("Soft Dollar" Arrangements) and Companion Policy 23-102 (the "Soft Dollar Rule"). The Soft Dollar Rule would clarify how advisers and registered dealers can use client brokerage commissions and include guidelines regarding disclosure of "soft dollar" arrangements.

Similar to existing policies of the OSC and the Autorité des marché financiers, advisers may not enter into any arrangements to use brokerage commissions to pay for goods and services other than order execution services or research which benefits clients. Research received must add value to investment or trading decisions, and the amount of brokerage commission paid must be reasonable in relation to the value of the services or research received.

The regulatory concern with respect to "soft dollars" is the potential for conflicts of interest by possibly providing incentives for advisers to place their interests ahead of their clients. This includes a possible incentive to direct trades to dealers for goods and services that benefit the advisers, and not their clients.

The comment period for the Soft Dollar Rule ends on October 19, 2006.

CSA Staff Notice on Principal Protected Notes

On July 7, 2006 the CSA published Canadian Securities Administrators' Notice 46-303 Principal Protected Notes (the "PPN Notice"). In recent years principal protected notes ("PPNs") have become a popular way of providing retail investors with access to hedge funds. The CSA note that approximately 25% of PPNs are linked to hedge funds and express concern that PPNs are being used to provide retail investors with access to such investment strategies. Other concerns raised by the CSA relate to disclosure, know your client and suitability obligations of registrants and referral arrangements.

The CSA state that they intend to consult with industry and stakeholders about the structuring and marketing of PPNs and consider whether new regulatory requirements or guidance are needed. The CSA make an interesting comment about the registration and prospectus exemptions relied on for the sale of PPNs:

Many types of PPNs are more complex and pose more investment risks than the type of product that was contemplated when securities legislation was enacted excluding financial institution deposits from securities regulation and exempting guaranteed debt instruments.

This could indicate a willingness to change such exemptions. That would have a significant impact on the PPN market.

The CSA also published Investor Watch Principal-Protected Notes to educate investors about PPNs.

MFDA Notice on Undivided Interests in Land

On July 6, 2006, the Mutual Fund Dealers Association (the "MFDA") published a Member Regulation Notice – Undivided Interests in Land . The purpose of the notice is to address investments in undivided interests in land being marketed by MFDA members to clients by way of referral arrangements. The MFDA cautioned that, regardless of how they are structured, such investments may be found by securities regulators to be investment contracts and, therefore, securities for purposes of securities legislation and MFDA rules. MFDA requirements for referral arrangements are set out in Member Regulation Notice MR-0043 . MFDA Rule 1.1.1 also requires that all securities related business be carried out for the account of and through the facilities of the MFDA member.

OSC Staff Notice on LMDs

On June 16, 2006, the Ontario Securities Commission (the "OSC") published OSC Staff Notice 11-758 Review of Limited Market Dealers (the "LMD Notice").

The LMD Notice describes the results of the OSC's first compliance review of limited market dealers that was conducted in 2005. It lists the ten most frequent deficiencies. The most significant deficiency was a failure to collect and document know your client and suitability information. This was identified in almost 80% of the LMDs reviewed.

OSC staff note that most of the LMDs they reviewed were only involved in the distribution of investment funds. However, they also noted that some performed multiple roles and were affiliated with the issuer. For example, they note that some LMDs also acted as general partners or portfolio managers for their funds without being registered as investment counsel/portfolio manager. In all such cases, the individual managing the portfolio did not meet the proficiency requirements for an IC/PM under Part 3 of OSC Rule 31-502 - Proficiency Requirements for Registrants .

As indicated by OSC staff, LMDs should ensure they, and any third parties with whom they have business arrangements, are appropriately registered for the activities in which they engage.

OSC Staff Notice on Model Portfolios

On May 26, 2006 the OSC published OSC Staff Notice 81-708 Model Portfolios of Mutual Funds (the "Portfolio Notice").

The Portfolio Notice addressed issues raised in certain exemption orders granted to RBC Asset Management Inc. (the "IC/PM") and Royal Mutual Funds Inc. (the "MFD") with respect to a model portfolio product. The MFD sells to its clients the model portfolio product, which is comprised of a number of mutual funds managed by the IC/PM. The IC/PM makes decisions concerning "rebalancing" the portfolio within pre-determined parameters and replacing existing funds in the portfolio with new funds. The IC/PM also trades mutual fund securities in order to carry out these discretionary rebalancing decisions.

OSC staff has clarified that they consider the "re-balancing" activity of the IC/PM to be discretionary management that directly affects the holdings of the clients of the portfolios (as distinct from a fund-of-funds in which the client continues to hold only one fund).

Staff consider the MFD to be providing discretionary management to the client without registration. Therefore, the MFD must be registered, or have an exemption from registration, as an adviser. The IC/PM, on the other hand, must be registered, or have an exemption from registration, as a dealer in order to make the trades to implement its discretionary authority for managing the portfolios. In the RBC case, the OSC and other members of the CSA granted exemptions from the dealer and adviser registration requirements to permit the portfolios to be sold as contemplated. Those exemptions were subject to some conditions, a number of which relate to disclosure. Disclosure requirements are also addressed in the Portfolio Notice. An exemption from the trade confirmation reporting requirement with respect to trades undertaken to implement re-balancing decisions of the IC/PM was also granted to the MFD.

It is interesting to note that the exemptions were granted in August 2005 but the decision documents were not published until May 2006 when the Portfolio Notice was published.

Investment fund managers and mutual fund dealers participating in the sale of model mutual fund portfolios should carefully consider whether their products are structured in such a way as to require the same type of relief as granted to RBC in respect of its product. Note that although the RBC product involves related portfolio manager and mutual fund dealer, the OSC has noted that a similar arrangement between arms length parties would be subject to the same requirements.

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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