The Finish Line: CSA Publishes Proposed Amendments in Final Phase of Modernization of Investment Fund Product Regulation
On September 22, 2016, the Canadian Securities Administrators (the “CSA”) published CSA Notice and Request for Comment – Modernization of Investment Fund Product Regulation – Alternative Funds (the “Proposed Amendments”). The Proposed Amendments represent the final phase of the CSA’s ongoing policy work to modernize investment fund product regulation in Canada (the “Modernization Project”). While primarily aimed at the development of a more comprehensive regulatory framework for commodity pool mutual funds that are currently governed by National Instrument 81-104 - Commodity Pools (“NI 81-104”), if adopted, the Proposed Amendments will also have a meaningful impact on other types of mutual funds, including conventional mutual funds and exchange traded mutual funds (“ETFs”), as well as non-redeemable investment funds (“NRIFs”).
Comments on the Proposed Amendments have been requested by the CSA on or before December 22, 2016. We would be happy to discuss any comments or concerns you may have with respect to the Proposed Amendments.
Background to Proposed Amendments
Phase 1 of the Modernization Project, which came into force in 2012, focused primarily on publicly offered mutual funds. The first stage of Phase 2 of the Modernization Project, which mostly came into force in September 2014, introduced core investment restrictions and fundamental operational requirements for NRIFs and also introduced enhanced disclosure requirements for securities lending activities by investment funds.
The Proposed Amendments are the second and final stage of Phase 2 of the Modernization Project and have been in development for some time. The CSA first published an outline of a proposed regulatory framework for alternative funds (the “Alternative Funds Proposal”) in March 2013. In June 2013, the CSA determined that it would consider the Alternative Funds Proposal at a later date in conjunction with certain investment restrictions for NRIFs that the CSA considered to be interrelated with the Alternative Funds Proposal (the “Interrelated Investment Restrictions”) as part of the second stage of Phase 2 of the Modernization Project.
Since NI 81-104 first came into force in 2002, the range of investment fund products and strategies in the domestic and international marketplace has expanded substantially. According to the CSA, the Proposed Amendments reflect the CSA’s efforts to modernize the existing commodity pools regime and to help facilitate more alternative and innovative investment strategies while maintaining the necessary restrictions to protect retail investors. The Proposed Amendments seek to move most of the current regulatory framework applicable to commodity pools in NI 81-104 into National Instrument 81-102 - Investment Funds (“NI 81-102”) and to rename these funds “alternative funds”. While the Proposed Amendments are principally focused on alternative funds, as mentioned above, they also include provisions that will impact other types of mutual funds, as well as NRIFs through the Interrelated Investment Restrictions. The highlights of the Proposed Amendments are summarized below.
Highlights of Proposed Amendments
1. Repeal of NI 81-104
- The CSA is proposing to repeal NI 81-104.
- The repeal of NI 81-104 will result in the operational framework and investment restrictions applicable to alternative funds being contained in NI 81-102 and will further the CSA’s goal of transforming NI 81-102 into the foundational operational rule for all investment funds.
2. Definition of “Alternative Fund”
- The CSA is proposing to replace the definition of “commodity pool” in NI 81-104 with a slightly broader definition of “alternative fund” in NI 81-102.
- “alternative fund” will be defined in NI 81-102 as a mutual fund that has adopted fundamental investment objectives that permit it to invest in asset classes or adopt investment strategies that are otherwise prohibited but for prescribed exemptions from the investment restrictions in Part 2 of NI 81-102.
3. Investment Restrictions
(a) Concentration Restrictions
- The CSA is proposing a concentration limit for alternative funds of 20% of NAV, rather than the 10% of NAV limit currently applicable to conventional mutual funds and commodity pools.
- The Proposed Amendments will impose the same concentration limit of 20% of NAV on NRIFs – which are not currently subject to any concentration restrictions under NI 81-102. According to the CSA, one of the reasons it is proposing to impose concentration limits on NRIFs is that many NRIFs already limit the concentration of their investments to 20% of NAV at the time of purchase. However, this would clearly create a problem for certain narrowly focused NRIFs which would need to alter their investment strategies.
(b) Illiquid Assets
- NRIFs currently are not limited in their ability to invest in illiquid assets. The CSA is proposing to introduce a limit on investing in illiquid assets for NRIFs to ensure NRIFs are able to meet their redemption obligations.
- Under the Proposed Amendments, NRIFs will not be permitted to invest in illiquid assets if, after the purchase, more than 20% of the fund’s NAV would be invested in illiquid assets, with a hard cap of 25% of NAV. The current investment restrictions on illiquid assets for mutual funds and commodity pools are 10% of the fund’s NAV, with a hard cap of 15% of NAV.
- The CSA is not proposing to increase the permitted level of investment in illiquid assets for alternative funds or for other mutual funds but is seeking feedback on whether a higher illiquid asset limit might be appropriate for alternative funds that are prepared to offer redemptions on a less frequent basis so they can devote a larger proportion of their portfolios to illiquid holdings.
(c) Fund-of-Fund Structures
- The CSA is proposing to permit mutual funds (other than alternative funds) to invest up to 10% of their net assets in securities of alternative funds and NRIFs provided those funds are subject to NI 81-102.
- The CSA is also proposing to permit mutual funds to invest up to 100% of their NAV in any other mutual fund (other than an alternative fund) that is subject to NI 81-102, rather than just those that file a simplified prospectus under National Instrument 81-101 – Mutual Fund Prospectus Disclosure (“NI 81-101”). The foregoing will codify existing exemptive relief and will permit a conventional mutual fund to invest up to 100% of its NAV in ETFs.
- The Proposed Amendments will also allow mutual funds to invest in another investment fund as long as it is a reporting issuer in at least one Canadian jurisdiction, i.e. doing away with the requirement that the investee fund be a reporting issuer in the investor fund’s “local jurisdiction”.
- Alternative funds will be permitted to invest up to 100% of their NAV in any other mutual fund (which includes other alternative funds) or NRIF provided the other fund is subject to NI 81-102.
- The CSA is not proposing to make any changes to the fund-of-fund rules for NRIFs.
(d) Borrowing, Short Selling and Combined Limit on Cash Borrowing and Short Selling
- The CSA is proposing to permit alternative funds to borrow up to 50% of their NAV and is also proposing to impose this borrowing limit on NRIFs which are not currently subject to any borrowing limits.
- The CSA is also proposing to make borrowing for alternative funds and NRIFs subject to the following additional conditions:
- Funds may only borrow from entities that would qualify as an investment fund custodian under s. 6.2 of NI 81-102, i.e. essentially banks and trust companies in Canada (or their dealer affiliates);
- Where the lender is an affiliate of an alternative fund’s investment fund manager, approval of the fund’s independent review committee will be required under National Instrument 81-107 – Independent Review Committee for Investment Funds (“NI 81-107”); and
- Any borrowing agreements must be in accordance with normal industry practice and be on standard commercial terms.
- The CSA is proposing to increase the aggregate market value of securities that can be sold short by alternative funds to 50% of the NAV of the fund, an increase from the 20% of NAV currently applicable to all mutual funds (including commodity pools). The CSA is also proposing to apply these limits to NRIFs which currently are not subject to any such restrictions.
- The CSA is also proposing to increase the aggregate market value of all securities of any issuer that may be sold short by an alternative fund to 10% of the NAV of the fund at the time of the short sale, an increase from the current limit applicable to mutual funds (including commodity pools) of 5% of NAV.
- The Proposed Amendments will also exempt alternative funds from the cash cover requirements in ss. 2.6.1(2) and (3) of NI 81-102.
- The CSA views short-selling as another form of borrowing and, as such, is also proposing to make the combined limit on cash borrowing and short-selling by alternative funds and NRIFs 50% of NAV.
(e) Use of Derivatives
- The CSA is proposing to codify exemptive relief (the “Dodd-Frank Relief”) frequently granted to mutual funds in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in the United States and similar legislation in Europe. The Dodd-Frank Relief is intended to facilitate entering into transactions for cleared derivatives under the infrastructure mandated by Dodd-Frank and similar legislation in Europe.
- The CSA is proposing to create a new definition for “cleared specified derivatives”, which will refer to any derivative cleared through the Dodd-Frank infrastructure, and will exempt all investment funds from the rules in ss. 2.7(1) and 2.7(4) of NI 81-102 for exposure to “cleared specified derivatives” and amend s. 6.8 of NI 81-102 in order to provide a specific exemption from the general custodian requirement to permit a fund to deposit assets with a dealer as margin in respect of cleared specified derivatives transactions.
- The CSA is proposing to exempt alternative funds from all of s. 2.7(1) of NI 81-102, including the designated rating requirements of ss. 2.7(1)(b) and 2.7(1)(c), to permit alternative funds to engage in OTC derivatives transactions with a wider variety of international counterparties. NRIFs are already exempt from s. 2.7(1) of NI 81-102.
- Subject to the general exemption for “cleared specified derivatives”, the CSA is proposing to make both alternative funds and NRIFs subject to the requirement to limit their mark-to-market exposure with any one counterparty to 10% with the intention of reducing credit risk to a single counterparty, particularly in connection with OTC derivatives.
- The CSA is proposing to retain exemptions for alternative funds and NRIFs from ss. 2.8 and 2.11 of NI 81-102 to permit them to use specified derivatives to create synthetic leveraged exposure.
- The CSA is proposing to create a single limit on the total leveraged exposure of an alternative fund or NRIF.
- The CSA is proposing that the aggregate gross exposure by an alternative fund or NRIF, through cash borrowing, short-selling and the use of specified derivatives, including through investing in underlying funds that employ leverage, cannot exceed 3x the fund’s NAV.
- On a daily basis – and not just at the time a transaction creating leverage is entered into – alternative funds and NRIFs will have to calculate:
Total amount of outstanding cash borrowed + Combined market value of securities the fund sells short + Aggregate notional amount of the fund’s specified derivatives positions (including those used for hedging purposes)
(g) Investments in Physical Commodities
- The CSA is proposing to expand the scope of permitted investments in physical commodities (the “Commodity Restriction”) for mutual funds that do not qualify as alternative funds to include the ability to invest directly in silver, palladium and platinum, in addition to gold (including certificates representing these precious metals), and to obtain indirect exposure to any physical commodity through the use of specified derivatives.
- Despite expanding the scope of the Commodity Restriction, mutual funds will still be limited to investing a combined 10% of their NAV at the time of purchase in physical commodities.
- Alternative funds and NRIFs will remain exempt from the provisions in NI 81-102 governing investments in physical commodities.
- In order to codify existing exemptive relief, the CSA is proposing to adopt the definition of “precious metals funds” currently in NI 81-104 into NI 81-102. Mutual funds that fit this definition will be exempt from the 10% limit on investment in physical commodities in respect of their investment in permitted precious metals.
4. New Alternative Funds: Seed Capital and Organizational Costs
- The CSA is proposing that alternative funds comply with the same seed capital and other start-up requirements applicable to other mutual funds under Part 3 of NI 81-102. As a result, the seed capital requirements for alternative funds will increase from $50,000 (the current requirement for commodity pools) to $150,000.
- The new start-up requirements for alternative funds in the Proposed Amendments will also mean that rather than having to maintain $50,000 invested in the fund, the seed capital of an alternative fund’s manager could be redeemed once there is $500,000 invested in the fund from outside investors.
- The CSA is not proposing to move the specific proficiency requirements in Part 4 of NI 81-104 for sales of commodity pool securities into NI 81-102 and will instead rely on the existing registrant regulatory regime.
- Notwithstanding the foregoing, the CSA is aware that in order to sell alternative fund securities additional education, training and experience requirements may be necessary for dealing representatives to fully understand the structure, features, and risks of the alternative fund securities that he or she may recommend. The CSA is engaging with the Mutual Fund Dealers Association of Canada to determine appropriate proficiency requirements to trade in securities of alternative funds and this process will be completed prior to the Proposed Amendments coming into force.
(a) Form of Prospectus/Point of Sale
- The CSA is proposing that alternative funds that are not listed on an exchange be subject to the simplified prospectus, annual information form and fund facts disclosure regime, with the fund facts having to be delivered at or before the point of sale.
- The new “ETF facts” summary disclosure document requirements, currently being finalized by the CSA, once in force, will also be applicable to listed alternative funds.
- The CSA is also proposing changes to the fund facts for alternative funds to include additional disclosure requirements regarding differences from other mutual funds in terms of investment strategies and permitted asset classes.
(b) Financial Statement Disclosure
- Part 8 of NI 81-104 currently requires commodity pools to include in their annual financial statements and interim financial reports disclosure regarding their actual use of leverage (the “Leverage Disclosure Requirements”) over the period in question.
- With the proposed repeal of NI 81-104, the CSA is planning to incorporate the Leverage Disclosure Requirements into NI 81-106, which will result in such requirements becoming applicable to NRIFs as well. The CSA is also proposing that the Leverage Disclosure Requirements apply to management reports of fund performance.
7. Transition/Coming Into Force
- Subject to the nature of any comments received and any applicable regulatory requirements, if approved, the CSA expects the Proposed Amendments to come into force approximately 3 months after their final publication date.
- The Proposed Amendments would:
- immediately apply to any investment fund that files a preliminary prospectus subsequent to the date the Proposed Amendments come into force; and
- apply to an investment fund that filed a preliminary prospectus but not a final prospectus when the Proposed Amendments come into force.
- The CSA is proposing a grandfathering period for existing funds of 6 months from the date the Proposed Amendments come into force (provided that the fund has filed its final prospectus before the Proposed Amendments come into force).
- The CSA is also proposing a grandfathering period from the fund facts pre-sale delivery requirements for existing funds of 6 months from the date the Proposed Amendments come into force.