As a result of their review of hedge funds in Canada, the Canadian Securities Administrators have concluded that the existing regulatory regime is generally adequate but have identified a number of areas for further study, including principal protected notes that provide exposure to underlying hedge funds and referral arrangements for hedge fund products.
On January 12, 2007 the Canadian Securities Administrators (CSA) published Staff Notice 81-316 Hedge Funds (Staff Notice). The Staff Notice reports on the CSA’s findings of its review of hedge funds in Canada. This update discusses the key findings of the CSA staff review.
Hedge Fund Review
The review was conducted from early 2005 through early 2006. It involved compliance reviews of hedge fund managers and advisers, disclosure reviews and industry consultations. Following the review, CSA staff concluded that "our regime contains an appropriate securities regulatory framework for hedge funds, but that certain areas within it could be improved."
Principal Protected Notes
CSA staff identified two topics for in-depth study. The first topic is principal protected notes (PPNs) that provide exposure to underlying hedge funds. CSA staff is concerned that:
- PPNs give retail investors access to alternative asset classes without the benefit of a prospectus;
- retail investors do not receive sufficient disclosure about the structure of PPNs and their fees and risks;
- PPNs that are linked to hedge funds are complex investments that include a higher level of risk than was contemplated when securities legislation was developed to exclude deposit instruments from securities regulation and to exempt guaranteed debt instruments from prospectus requirements. (PPNs are generally structured as deposit instruments or guaranteed debt instruments); and
- registrants who sell PPNs may not be meeting their "know your client" and suitability obligations. On July 7, 2006 the CSA issued CSA Notice 46-303 Principal Protected Notes. That Notice outlined the CSA’s concerns and signalled the CSA’s desire for further consultation.
CSA staff identified referral arrangements as a second area for in-depth study. Although registrants who give or receive referrals are bound by specific obligations under securities legislation as well as a general obligation to act in the best interests of their clients, CSA staff believe that these obligations may need further clarification.
CSA staff are concerned about the confusion between the registrants involved in the referral about who must disclose a referral arrangement to the client, and the possibility that a registrant will be motivated to refer a client to a hedge fund product because of a significant referral fee and not because the product is in the client’s best interests. The CSA is studying referral arrangements for hedge fund products through the CSA Registration Reform Project.
Additional Areas of Concern
In addition to these two areas, the Staff Notice identifies four other areas of concern and possible future action. These are:
- ensuring dealers and their salespersons have sufficient knowledge of hedge fund products to adequately assess suitability of the products for clients;
- proposing a system of manager registration through the Registration Reform Project;
- ensuring clear language in non-prospectus disclosure documents, such as offering memorandums and marketing materials that include performance data; and
- studying the challenges faced by hedge funds in complying with NI 81-106 Investment Funds Continuous Disclosure.
Task Force Recommendations
In their review, CSA staff consulted the report issued by the Task Force to Modernize Securities Legislation in Canada issued in October, 2006 (Allen Report). Chapter Six of the Allen Report discusses hedge fund regulation and contains four recommendations that are similar to those contained in the Staff Notice. In broad outline, the four recommendations are:
- establishing a regulatory framework for the public offering of hedge funds that requires certain disclosures;
- regulating PPNs according to the nature of their underlying investment (such as a hedge fund) rather than their external form, which may be exempt from the securities legislative framework;
- requiring all financial intermediaries that sell hedge fund products, including PPNs, to meet certain proficiency and knowledge requirements; and
- considering a registration requirement for hedge fund managers.
A copy of the Staff Notice can be found at several CSA members' websites. It is available on the OSC’s website at:
We will keep you advised of further developments in the regulation of hedge funds and PPNs including the fund manager registration requirement that will be published for comment by the CSA in February, 2007.
Andrew Aziz is a partner in Osler's Business Law Department. His practice covers many areas of corporate and securities law. John Black is a partner in the Business Law Department in the firm’s Toronto office. He practises in the areas of corporate and securities law. Linda Currie is a partner in the firm's Business Law Department. Her practice is concentrated in the corporate and securities law area. Mark DesLauriers is a partner in the firm's Toronto office where he practises in the area of corporate and securities law.
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