Proposed National Instrument 31-103: Impact On The Hedge Fund Industry

While the media and other observers have suggested that proposed National Instrument 31-103 Registration Requirements¹ responds to perceived concerns about the Canadian hedge fund industry, proposed NI 31-103 is principally designed to put in place a revised, nationally harmonized and streamlined registration regime for firms and individuals. Recent hedge fund scandals may have provided the catalyst to speed up implementation of national registration rules by focussing the regulators’ attention. However, the genesis of a national registration system predated the Canadian securities regulators’ review of the hedge fund industry². The reality is that Canadian hedge fund managers already are under the regulatory umbrella of the Canadian securities regulators because they must register as advisers (investment counsel/portfolio managers) if they provide portfolio management services to the funds. However, proposed NI 31-103 can be expected to put to bed current regulatory debates about registration requirements for hedge fund participants, including general partners of hedge funds organized as limited partnerships, and will impose other regulatory requirements on industry participants.

Proposed NI 31-103 will expand or clarify existing regulation of hedge fund managers, advisers and distributors by

• Introducing a new category of registration for "investment fund managers"
• Introducing a registration category of "exempt market dealer" across Canada
• Introducing a new "business trigger" test for determining when registration is required
• Increasing capital and insurance requirements across all categories of registration
• Changing proficiency requirements for individual registrants
• Enhancing compliance and supervisory expectations
• Governing referral arrangements
• Increasing financial reporting requirements

Registration of Investment Fund Managers – The new registration category of "investment fund manager" will apply to managers of all investment funds, including domestic and international managers, as well as funds that are reporting issuers and privately offered. The term "investment fund manager" is defined in Ontario securities regulation as "a person or company who has the power and exercises the responsibility to direct the affairs of an investment fund". It is unclear whether the CSA intend to capture, for example, general partners of hedge funds organized as limited partnerships and trustees of hedge funds organized as trusts. However, in our view, registration of these entities should not be required if they delegate management duties to a registered third party manager, and we intend to request that the CSA clarify this important point in the proposed companion policy to proposed NI 31-103.

Exempt Market Dealer Registration – At present, only the securities regulators in Ontario and Newfoundland and Labrador require dealers trading in securities pursuant to prospectus and registration requirements to register as "limited market dealers" (LMDs). Proposed NI 31-103 introduces a new registration category for dealers, "exempt market dealers", that will replace the LMD category and apply across Canada. Unlike the LMD category, a registered exempt market dealer will be subject to minimum capital and insurance and proficiency requirements for its dealing representatives, its ultimate designated person and its chief compliance officer. Existing registrants will not be grandfathered, although transitional provisions have not yet been published.

Registration Exemptions and the "Business Trigger" – Today’s securities legislation imposes a "business trigger"³ for determining whether an entity must register as an adviser. In contrast an entity is caught today by the dealer registration requirements simply by participating in a trade. Proposed NI 31-103 will introduce the business trigger test in all provinces and territories and across all registration categories. This will likely not impact on those currently servicing hedge funds and their managers, however it is expected to relieve a firm that is involved in mergers and acquisitions or private equity investment from registration where its focus is on investing in or assisting in the management of a business, as opposed to investing in securities of an issuer.

Increased Capital and Insurance Requirements – We expect that the new capital and insurance requirements of proposed NI 31-103 will have a significant impact on hedge fund industry participants. Minimum capital required for investment fund managers will be $100,000; for dealers $50,000; and for portfolio managers $25,000. Generally, the required capital will be adjusted upward to reflect total assets or assets under management, deductibles under required insurance policies and other risk-related factors. For firms registered in more than one category, these minimums will not be cumulative.

Minimum insurance requirements will also increase for firms with significant assets or assets under management to as high as $25,000,000 in some cases.

Changes to Proficiency Requirements – Dealing representatives of exempt market dealers will be required to have passed the Canadian Securities Exam and the Conduct and Practices Handbook Exam or the PDO Exam, or the equivalent U.S. courses and the New Entrants exam, or meet the requirements for an advising representative. Changes are also proposed for the required proficiency of advising representatives and associate advising representatives.

Conduct Rules – Proposed NI 31-103 emphasizes that compliance is not the sole responsibility of the ultimate designated person or the chief compliance officer or a designated individual in a firm but that compliance is a firm-wide responsibility. A registered firm will be required to establish and enforce a system of controls and supervision that ensures the firm’s compliance with all applicable requirements. This system of controls must be documented in the form of written policies and procedures. The registered firm will also be required to ensure that its compliance monitoring and supervision policies and procedures take into account conflicts of interest management issues.

Proposed NI 31-103 recognizes that many fund management duties, for example "back office" administration, are delegated to third party service providers. All registrant firms will be required to conduct appropriate due diligence on all such service providers and to regularly monitor their activities. Ultimate responsibility for the actions of the service providers will remain with the registrant.

Referral Arrangements – Proposed NI 31-103 codifies current CSA policies and suggested best practices regarding referral arrangements. All such arrangements will have to be in writing and clearly allocate responsibility for discharging regulatory duties, such as know-your-client and suitability requirements. Registrants will have to ensure that investors are fully informed of all such arrangements and payments made under them.

Financial Reporting – In addition to the filing of annual audited financial statements and required forms, proposed NI 31-103 will require additional reporting requirements for certain registrants. Investment fund managers will be required to file quarterly statements and forms (including a description of any net asset valuation adjustments made in the period). All registrants will be required to immediately report any shortfall in minimum regulatory capital.