Comment Deadline: October 17, 2009
The Canadian Securities Administrators have released draft rules that would implement the first stage of the CSA's goal to improve mutual fund disclosure. Draft amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure and its companion policy, along with consequential amendments to other national instruments, were released for public comment on June 19, 2009 [click here for the proposals]. Comments on the proposals must be submitted to the CSA by October 17, 2009.
The amendments are designed to implement the revised disclosure proposals recommended by the Joint Forum of Financial Market Regulators in the October 2008 Framework 81-406 Point of sale disclosure for mutual funds and segregated funds. The CSA have, to a limited extent, taken into account the comments provided to the CSA on the above-noted Framework, but continue to ask for feedback on the costs and other issues associated with the current proposals. Some concessions have been made by the CSA in response to comments, but many of the same concerns as were raised with the Framework continue to exist.
In concert with the CSA, the Canadian Council of Insurance Regulators (CCIR) is also consulting on changes to the regulatory framework that applies to segregated funds. The CCIR is working with the Canadian Life and Health Insurance Association of Canada (CLHIA) and its members in recommending changes to CLHIA's Guideline G-2 on Individual Variable Insurance Contracts Relating to Segregated Funds to implement improved disclosure and investor rights for purchasers of segregated funds. On June 26, 2009, the CCIR published for comment a consultation document entitled Implementation of the Joint Forum Point of Sale Framework for Segregated Funds [available here], which consists of the sections of CLHIA Guideline G-2 that will change as a result of implementing the Joint Forum Point of Sale Framework. Comments on this consultation paper are requested by September 11, 2009.
Mutual Fund Disclosure — Background
The Proposed System
The CSA proposals consist of draft amendments to National Instrument 81-101 and its companion policy, as well as a proposed form for the fund facts document. The proposals contain detailed, prescriptive rules for the creation of the fund facts document, as well as for its delivery to investors. The CSA explain that their proposals are built on three central principles
- Providing investors with key information about a mutual fund
- Providing the information in a simple, accessible and comparable format and
- Providing the information before investors make their decision to buy.
The cornerstone of the proposed disclosure regime continues to be the fund facts document that must be developed for each series or class of securities of a mutual fund. The fund's simplified prospectus and annual information form must still be prepared and filed, but will not be given to investors unless requested. Dealers will, generally, be required to give an investor the most current fund facts before placing an "initial" order for securities of a mutual fund. Delivery can be achieved in person, by regular or electronic mail, via fax, or by providing a specific link to the fund facts posted on a website. Dealers also must bring to their clients' attention the fund facts once it has been delivered, and before finalizing the trade. Posting of fund facts on a fund company's website will be required, but will not eliminate the requirement for an advisor to provide the investor with a paper or electronic copy or a precise link to where a specific fund facts is posted.
Content Of The Fund Facts
The proposed fund facts form details highly prescriptive and precise requirements for the content of the fund facts. A sample fund facts document is attached to the proposed amended companion policy to National Instrument 81-101.
- A mutual fund must have a separate fund facts for each of its classes or series of securities. The CSA suggest that they will consider alternatives, and ask for samples of fund facts documents that contain multiple classes or series disclosure, although they note that they have not, as yet, seen a sample consolidated fund facts that they believe meets the disclosure principles described above.
- Generally a fund facts must fit on two sides of one piece of "letter-sized" paper, although if more disclosure is necessary to respond to the requirements, the document can be three pages long.
- Fund facts will be in two parts (i) Part I – Information about the Fund and (ii) Part II – Costs, Rights and Other Information. Generally Part I will be on the first side of the page and Part II will be on the flip side.
- Headings and sub-headings are mandated, as are prescribed tables and some wording.
- Fund facts must be written in plain language and be at or below a grade 6.0 reading level using the Flesch-Kincaid grade level system1. Managers must provide the regulators with a letter confirming the Flesch-Kincaid grade level of each of the fund facts for the various classes or series of their funds, which confirmation we note may be a relatively time-consuming exercise.
- Unless a material change has occurred, the fund facts need only be updated annually at the time of the annual renewal of the simplified prospectus and annual information form, although it may be updated as frequently as quarterly at the option of the fund manager. Given the logistical complications that more frequent updating may entail, we anticipate that most fund managers will not opt to update the fund facts more frequently than annually.
In our view, some proposed disclosure items will be controversial and, in some cases, may result in inadequate information being provided to investors about the mutual fund. We also are concerned that given the level of detail required for certain disclosure items, it may be very difficult to meet the mandatory page limits for each fund facts. For certain items, the CSA specifically request feedback.
- The investment objectives and strategies of the fund are to be abbreviated and should not simply copy the disclosure in the simplified prospectus. For example, investment strategies are to be included only if it is an essential aspect of the fund, as evidenced by the name of the fund or the manner in which it is marketed. For certain funds, such as index funds, the disclosure required is more extensive. We note that this abbreviated disclosure is even more abbreviated than that expected under National Instrument 81-106 for management reports of fund performance.
- MERs must be disclosed without taking into account any waivers or absorption of fees. The CSA indicate that they believe this is more appropriate, considering that " there is no guarantee" that such waivers or absorptions will continue.
- The CSA are considering whether to require disclosure of the trading expense ratio of each fund.
- Not only are year-by-year returns to be provided in a bar chart format similar to that required by National Instrument 81-106, the fund facts must specifically disclose the number of years in which the value of the mutual fund has dropped over the past ten years.
- Risk disclosure is not to be provided in narrative form, but in a tabular format indicating where the manager believes the fund's "risk" is on a five item range from low to high. No particular risk measurement is mandated which is a change from the October 2008 Framework. However, the fund manager must have a methodology and must explain that methodology in the simplified prospectus for the fund. The CSA ask for comment on these risk disclosure proposals, including whether or not some narrative disclosure of key risks should be permitted at the option of the fund manager.
- Fund expenses are to be provided as an annual percentage of the fund's net asset value, similar to today's disclosure of management fees, operating expenses and MER, but without any narrative. We note that the required disclosure will not easily allow for an explanation of situations where the fund pays fixed administration fees. Trailing commissions paid by fund managers out of the management fees must be specifically highlighted under a "trailing commission" sub-heading, where narrative discussion of trailing commissions will be required. The CSA indicate that they are considering requiring an illustration of the amounts payable by funds in "dollars and cents".
Delivery Of The Fund Facts
Consistent with the Framework, the proposed disclosure rules recognize that delivery of the fund facts will not be necessary for every trade. The rules are very specific about how and when the fund facts must be delivered.
- Identifying a trade as "advisor-recommended" versus "investor-initiated" will be important. With the latter, the dealer may obtain client consent to send the fund facts with the trade confirmation, on the assumption that the client has conducted his or her own research about the fund and therefore doesn't need the fund facts to make an informed decision. Note that in all cases, the client must waive receipt of the fund facts before the trade, on a trade by trade basis. The CSA explain that they do not consider that a client can waive receipt of the fund facts on a blanket basis on account opening, for example. In addition, in these circumstances, the proposed rules suggest that a dealer must first explain the content of a fund facts to the client so the client can make an informed decision about whether or not to waive his/her right to receive it.
- Dealers that provide an "order execution-only service" (discount brokers) must provide the fund facts with the trade confirmation, but need not provide the fund facts before the trade is completed, presumably on the principle that all trades with a discount broker are "investor-initiated".
- Clients may consent to receive the fund facts for a money market fund with the trade confirmation, since money market funds are lower risk and are generally used by investors to "park" money temporarily. To consent, clients must waive receipt of the fund facts at the point of sale in same way as "investor-initiated" trades.
- Complex rules about binding and packaging of fund facts for delivery to investors are provided, with the CSA giving their views that a document with 10 fund facts bound together would likely be too much and may "discourage" an investor from reading the documents and would "obscure key information" about each mutual fund. A fund facts that is delivered electronically cannot be "attached to or bound with another fund facts documents".
- No fund facts need be delivered to an investor on a subsequent trade in a mutual fund, provided the client already holds securities of the same class or series in the particular fund. The requirement to deliver a fund facts prior to purchase is only in respect of "initial trades" in mutual funds. The term "initial trade" is defined in the proposed rules and includes a purchase of securities of another class or series of the same mutual fund that the client already holds. Note that the CSA have asked for comments on this and suggest that they are "rethinking" the proposal that no fund facts need be delivered on a subsequent trade.
- Investors must be given the option of annually receiving a fund facts for the funds they hold. Dealers can ask clients to give annual instructions or standing instructions similar to the regime established for delivery of continuous disclosure documents (the financial statements and MRFPs) in National Instrument 81-106. Dealers can ask for standing instructions and assume that a non-answer means "no annual delivery of fund facts", provided that the outcome of a negative response is described properly.
The proposed amendments to National Instrument 81-101 contain the two-day "cooling off period" suggested in the Framework, but do not fully explain how the CSA intend to change the various investor rights contained in provincial securities legislation. For most provinces, other than Ontario and Québec, it would appear that the applicable CSA member believes that it has the power to amend legislation by rule, in that the rule expressly provides that the rights contained in securities legislation does not apply. Although the Ontario Securities Commission (OSC) does not separately explain its reasoning, the amendments to National Instrument 81-101 suggest that Ontario's legislated right of rescission (section 137 of the Securities Act (Ontario)) will continue and cannot be modified by rule.
We believe that the area of investor rights, including rights of investors to claim damages for misrepresentation contained in any of the disclosure documents, deserves close scrutiny. In our view, the CSA proposal leaves considerable uncertainty for the fund industry and investors alike, and we will be providing our comments to the CSA.
The CSA are considering implementing the rule amendments in stages with a two-year phase-in period for delivery of fund facts in advance of trades. Fund managers would be required to prepare and file fund facts and make them available to investors at the end of the first renewal period after the effective date for the proposed amendments. The CSA are also considering modifying current requirements to allow dealers and fund managers to deliver the fund facts in satisfaction of today's prospectus delivery requirements (post-trade delivery of simplified prospectuses). In addition to requesting comments on transition timing, the CSA are requesting specific feedback on the costs to the industry of the new regime.
We note that the transition timing is such that, even with a fast track effort of the CSA to bring the proposed amendments to National Instrument 81-101 into force within a year (by June 2010), that most mutual funds would not be required to create fund facts until late 2010 or 2011 and "point of sale" delivery of fund facts would not occur until after June 2012 at the earliest.
We are pleased that the CSA suggest that, as a second stage, they will be reviewing the remainder of the disclosure documents required by National Instrument 81-101, although they have indicated that they will not be reviewing the continuous disclosure regime set out in National Instrument 81-106.
We continue to believe that the proposed disclosure regime does not appropriately recognize the purpose of an effective disclosure regime in today's wired and literate society (particularly as it may exist in 2012), nor does it recognize the value provided by dealers and advisors to investors who seek advice.
In our view, a mutual fund should prepare a primary disclosure document that simply and concisely describes its fundamental features, including all of its classes or series of securities. This document should be readily available to investors, to dealers and to the public at large. Its purpose would be to set out the essential commercial terms that investors should understand about the fund. The primary disclosure document would be, to the greatest extent possible, "evergreen" and would not be bifurcated into a simplified prospectus and an annual information form. Information about the on-going operations of the mutual fund would continue to be provided in continuous disclosure documents (that is, the financial statements and MRFP) and should not be repeated in the primary disclosure document. Securities regulation should mandate the content and production of these documents, as well as their accessibility through website postings and physical delivery to those investors who ask for them. We recognize that a fund manager may wish to have a simple summary of basic facts about a mutual fund available for investors and advisors on its website, but we do not believe that it is necessary for securities regulation to mandate the contents of this document or its delivery prior to an investment being made.
The suitability, know-your-client and know-your-product obligations of a dealer and its advisors in connection with mutual fund investing are well-known and of long-standing in Canada. In our view, securities regulation should reinforce the responsibilities of dealers and advisors to highlight the availability of disclosure documents when making recommendations to investors. We are not convinced of the necessity for a paper-based delivery of a disclosure document prior to a trade taking place.
However, we recognize that there is growing global regulatory support for some form of point of sale disclosure being made available to mutual fund investors. In a June 17, 2009 report of the United States' government entitled Financial Regulatory Reform – a New Foundation: Rebuilding Financial Supervision and Regulation, the authors recommend that the Securities and Exchange Commission (SEC) should be authorized to require that "certain disclosure (including a summary prospectus) be provided to investors at or before the point of sale, if it finds such disclosure would improve investor understanding of the particular financial products, and their costs and risks. ... Without slowing the pace of transactions in modern capital markets, the SEC should require that adequate information is given to investor [sic] to make informed investment decisions".
BLG's Investment Management Group have closely followed the progress of the CSA's work to enhance mutual fund disclosure. We are proud to have worked with many mutual fund groups over the years to prepare the mandatory disclosure documents for mutual funds and ensure compliance with the various new and modified requirements, including plain language disclosure.
Our Investment Management Advisories written in 2007 and 2008 on the Proposed Framework and Framework are available [here] and [here], and provide additional background. We have participated in the comment process by submitting comment letters to the CSA on both the Proposed Framework and the Framework. We intend to comment on the proposed amendments to National Instrument 81-101 and we would be pleased to assist you in providing your comments to the CSA. In particular, we would be pleased to assist you in preparing sample fund facts that contain the suggested disclosure or alternatives to that disclosure for submission to the CSA for their consideration.
John Hall, the National Leader of BLG's Investment Management Group, has been an active member of IFIC's point of sale disclosure committee and continues to participate in that group's deliberations. Rebecca Cowdery, while she was at the Ontario Securities Commission (OSC), was in charge of the CSA projects that resulted in National Instrument 81-101 coming into force in 2000 and later the release of the Joint Forum's 2003 Consultation Paper.
1. The English version of this Advisory is written at a grade 10.0 level on the Flesch-Kincaid system using the test available on Google Documents.
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.