- Harmonized Securities Regulation For Canadian Public Investment Funds Finalized With Twists (But There’s More To Come)
- July 21, 2014 | Authors: Rebecca A. Cowdery; Carol E. Derk; K. Ruth Liu; Lynn M. McGrade
- Law Firm: Borden Ladner Gervais LLP - Toronto Office
On June 19, 2014, the Canadian Securities Administrators (CSA) published final amendments to National Instrument 81-102 Mutual Funds - to be renamed Investment Funds - and related instruments as part of Phase 2 of the CSA’s project to modernize the regulation of publicly offered investment funds. Subject to government approvals, the rule amendments will come into force on September 22, 2014, with specific transition and grandfathering provisions for certain provisions. The CSA’s release is available here.
The rule amendments will transform NI 81-102 into a rule that will regulate all publicly offered investment funds - not just public mutual funds - by introducing core operational requirements and investment restrictions for non-redeemable investment funds that mirror certain rules that apply to mutual funds. The amendments to NI 81-102 will also impact mutual funds in potentially significant ways. Amendments will also be made to National Instrument 81-106 Investment Fund Continuous Disclosure, National Instrument 81-101 Mutual Fund Prospectus Disclosure,National Instrument 81-107 Independent Review Committee for Investment Funds and National Instrument 41-101 General Prospectus Requirements, as well as to the companion policies to some of the affected instruments. The amendments to NI 81-106 and the prospectus disclosure rules impose new disclosure requirements in respect of securities lending activities of all public investment funds and generally will be effective for financial years commencing January 1, 2016, with the prospectus disclosure requirements effective on September 22, 2014.
Although the CSA pulled back on some of the more controversial 2013 proposals in connection with closed-end funds, the rule amendments still can be expected to have a significant effect on these funds in Canada (defined by the CSA as “non-redeemable investment funds”) and potentially the universe of investment options for Canadians. The rule amendments impose, among other things, new restrictions on investments and investment practices, a prohibition on issuing warrants, as well as requirements for proposed fundamental changes to the funds, custodianship, marketing via sales communications and processing of redemptions.
And the CSA have indicated that there is more to come at a later date, as the CSA continue to consider an “alternative funds” regime. This regime will likely impact mutual funds relying on National Instrument 81-104 Commodity Pools and can be expected to impose further restrictions on closed-end funds presently using derivative strategies, including to gain exposure to commodities, and engaging in short selling strategies.
Revised NI 81-102 - At A Glance
Any transition provided for generally will only apply to investment funds that are existing and have filed a prospectus on or before September 22, 2014. The CSA use the term “non-redeemable investment fund” - we use the term “closed-end fund” in this Bulletin. Unless otherwise indicated, the provisions for closed-end funds will apply in substantially the same way as for mutual funds.
The New Regime For Investment Funds
The amendments to NI 81-102 and related instruments introduce a number of investment restrictions and operating requirements for publicly-offered closed-end funds. There are also many amendments - some minor, with some that are more substantive ¿ for mutual funds, which in this context includes exchange-traded funds structured as mutual funds (ETFs).
Given the extent of the changes, managers of all investment funds, but, particularly closed-end funds, should consider the impact of the amendments carefully. Some of the changes brought about by the amendments will likely require a manager of a closed-end fund to amend the investment strategies of the fund and may require it to divest certain investments. Investment fund managers will also want to review (and revise as necessary) agreements with service providers and change and enhance their compliance policies and procedures. Independent review committees of closed-end funds will take on additional duties as a matter of law, and these revisions should be discussed with the members of IRCs before their implementation date of September 22, 2014.
Depending on the nature of the closed-end fund and its investments and structure, it may be beneficial and advisable to seek exemptive relief from certain of the provisions. This relief should be sought as soon as practicable to be ready for the implementation dates.
It should be noted that NI 81-102 and the amendments in the related instruments apply to public investment funds, including mutual funds, ETFs, closed-end funds and any other public “non-redeemable investment fund”. These amendments do not, however, apply to scholarship plans which will continue to be regulated by the CSA pursuant to administrative policy through the annual prospectus filings made by these investment vehicles, pending any specific rule-making.
Control Restrictions Closed-end funds will not be permitted to purchase more than 10 percent of the outstanding equity securities of an issuer, or purchase a security for the purpose of exercising control or management over the issuer.
The CSA have also amended the Companion Policy to NI 81-102 to reflect their position regarding when an investment fund would be considered to have control over, or be involved in the management, of an investee company. Any investment fund that would fall within the CSA’s guidance should carefully consider its options, which may impact the need for a registered investment fund manager, as well as the governance and disclosure requirements that apply to the fund.
Investments in Real Property, Mortgages and Loan Syndications Closed-end funds will not be permitted to purchase real property, mortgages (other than guaranteed mortgages) or an interest in a loan syndication or loan participation if the purchase would require the fund to assume any responsibilities in administering the loan in relation to the borrower. Existing closed-end funds that invest in mortgages may be able to take advantage of the grandfathering provisions.
Many mortgage investment corporations (MICs) and similar investment vehicles are not considered to be “investment funds” (see CSA Staff Notice 31-323 Guidance Relating to the Registration Obligations of Mortgage Investment Entities and OSC Staff Notice 81-722 Mortgage Investment Entities and Investment Funds) and therefore will be outside the scope of these amendments. However, to the extent some MICs and other similar investment vehicles are investment funds, the amendments could have a significant impact on their strategies if they invest in mortgages other than guaranteed mortgages.
Fund-of-Funds A closed-end fund may only invest in another investment fund (a mutual fund or another closed-end fund) if, among other things, the underlying fund is subject to NI 81-102 or complies with the provisions of NI 81-102 applicable to a non-redeemable investment fund, and is a reporting issuer in at least one Canadian jurisdiction.
As of March 21, 2016, a mutual fund will be prohibited from investing in a closed-end fund, unless the fund fits within the definition of “index participation unit”. As of this transition date, mutual funds will only be able to invest in “investment funds” that are other mutual funds subject to NI 81-102 and NI 81-101 (except if the fund is an IPU). This prohibition can be expected to restrict the universe of investment options for mutual funds.
Securities Lending, Repurchase and Reverse Repurchase Transactions The requirements and conditions relating to these types of transactions will extend to closed-end funds. In addition, for all publicly-offered investment funds, including mutual funds, the aggregate market value of securities loaned under securities lending transactions or sold in repurchase transactions by the fund must not exceed an amount equal to 50% of the net asset value (previously total assets), of the fund. The CSA indicate that this is meant to address the effect of leverage employed by investment funds, which could result in the fund having a greater total asset value than its net asset value.
Conflicts of Interest Part 4 of NI 81-102, which includes provisions relating to prohibited investments by dealer-managed funds, self-dealing transactions and liability and indemnification matters for funds, will apply to closed-end funds. This will impact the IRCs for these funds, given the additional duties it will take on by law.
Investor and Regulatory Approval or Notice Requirements for Fundamental Changes A mutual fund will be required to seek investor approval for: (i) a merger with any issuer (not just another mutual fund) and (ii) a restructuring into a non-redeemable investment fund or into an issuer that is not an investment fund. The fund will not be permitted to bear any of the costs or expenses associated with such structuring. To effect a merger without investor or regulatory approval, a mutual fund will be required to offer to its investors consideration that has a value that is equal to the net asset value of the fund on the date of the merger.
Part 5 of NI 81-102 also will be extended to closed-end funds.
- Matters Requiring Investor Approval In addition to the matters that require investor approval if proposed for mutual funds, a closed-end fund will be required to seek investor approval before restructuring into a mutual fund or an issuer that is not an investment fund. The fund is not permitted to bear any of the costs or expenses associated with such a restructuring. There is a carve-out from such investor approval requirement for the restructuring of non-redeemable investment funds, typically known as “flow-through funds”, provided certain conditions are met.
- Pre-Approved Mergers The requirement to seek investor and regulatory approval for certain fund mergers will apply to closed-end funds. To effect a merger without investor or regulatory approval, investors must be permitted to redeem their securities at a price equal to the net asset value of such securities at a date that is before the effective date of the merger. IRCs of closed-end funds should be aware of their expanded duties in this regard.
- Fund Termination Closed-e nd funds that wish to terminate must file a press release at least 15 days and no more than 90 days before the date of termination.
Subscriptions and Redemptions The issuance of securities of an investment fund must not cause dilution to existing investors. Closed-end funds will also be subject to some of the provisions regarding redemptions of fund securities in NI 81-102, including the requirement to send to investors an annual reminder of the applicable redemption procedures, a restriction on redeeming securities at a price that is greater than the net asset value of the securities on the redemption date, requirements to pay redemption proceeds within 15 business days after the effective date of the redemption and the ability to suspend redemptions only if certain conditions are met.
Warrant Offerings Investment funds will be prohibited from issuing a conventional warrant or right, or entering into a derivative transaction where the underlying interest is a security of the fund.
Other Provisions Closed-end funds will be subject to the provisions relating to commingling of cash and sale communications in NI 81-102, which are amended to reflect the differences between mutual funds and closed-end funds.Where a mutual fund that was converted from a non-redeemable investment fund presents performance data, it must include past performance data for the period when it existed as a non-redeemable investment fund.
Securities Lending Transactions All investment funds will be required to disclose, in their prospectuses or annual information forms, as applicable, the name of the securities lending agent, the relationship of such agent to the fund manager and a description of the essential terms of any agreement with the agent. They will also be required to disclose, in their financial statements, a reconciliation of the gross amount generated from such transactions to the revenue disclosed in its statement of operations. This disclosure is intended to give investors information about related party revenue sharing arrangements. Closed-end funds will be subject to the same securities lending provisions as mutual funds.
The CSA’s Next Initiative - Alternative Funds
The CSA do not provide much additional information about the status of their project to consider an “alternative funds” regime, other than to explain that this policy initiative is on-going. Certain of the more controversial elements of the 2013 proposals have been shelved for the time being pending the CSA’s consideration of the alternative funds regime. We note those provisions in the table in the preceding pages of this Bulletin and anticipate these proposals are being considered and are certainly not forgotten. The CSA do not summarize the comments that were made in response to the request for comments on their 2013 proposals, but explain they will do so when they release their alternative funds proposal. Our thoughts on the alternative funds proposal are outlined in our April 2013 Bulletin highlighted as follows.
CSA Modernization Project For Investment Funds: 2010-2014
The CSA first announced their modernization project for investment funds in June 2010. Phase 1 of the CSA’s modernization project was completed on April 30, 2012, when various updated mutual fund rules set out in NI 81-102 came into force. New money market fund rules were effective on October 30, 2012. The Phase 2 rule amendments described in this Bulletin were first published for comment on March 27, 2013 and were the subject of extensive industry comments (over 49 comment letters were submitted during the extended comment period, including from Borden Ladner Gervais LLP), some of which have caused the CSA to rethink their proposals. Notwithstanding the significant changes made with the final amendments, no further comment period was considered necessary by the CSA. With the 2014 rule amendments coming into effect, the first phase of the CSA’s Stage 2 of the modernization project will be complete. It is not clear whether the CSA will continue with their previously announced plan to review the investment restrictions applicable to mutual funds to assess whether changes should be made in light of “market and product developments”, or whether this will be subsumed into the CSA’s review of the “alternative funds” regime that can be expected to apply to all investment funds wishing to engage in these strategies. No time frame has been announced for this further work....
All managers of public investment funds will need to pay close attention to the revisions to NI 81-102 and the other related instruments, given the extensive nature of the changes and their potential impact on their business and compliance procedures. Please contact your usual lawyer in BLG’s Investment Management practice group, the authors of this Bulletin or one of the leaders of the Investment Management practice group listed below if you have any questions on the new rules or if we can assist you in transitioning to the new requirements.