Investment Fund Amendments Would Bring Sweeping Changes to Closed-End Fund Regime
Recently, the Canadian Securities Administrators (CSA) released proposed amendments (CSA Proposal) to National Instrument 81-102 – Mutual Funds (NI 81-102) that would impose on closed-end funds certain investment restrictions and operational requirements that currently apply only to conventional mutual funds and exchange-traded funds (ETFs). The CSA Proposal* is likely to be of great interest to managers of closed-end funds, as well as to the entire investment fund community.
In conjunction with the CSA Proposal, the CSA plans to create a comprehensive framework for "alternative funds" through amendments to National Instrument 81-104 – Commodity Pools (NI 81-104). This "Alternative Funds Framework" would allow mutual funds and closed-end funds to use alternative investment strategies that would otherwise be unavailable under NI 81-102. The CSA is seeking feedback on some aspects of the proposed Alternative Funds Framework, though no specific NI 81-104 amendments have been published for comment.
Key features of the CSA Proposal include the following:
The cost of launching a new closed-end fund
Under the CSA Proposal, none of the costs of launching a new closed-end fund may be borne by the closed-end fund or its securityholders. This would require managers to pay the costs of establishing new closed-end funds, which is a significant reversal of current market practice.
1. Concentration restriction
A closed-end fund would be prohibited from investing more than 10% of its net asset value (NAV) in any one issuer. This restriction would not apply to a closed-end fund that has a fundamental investment objective of holding and maintaining a fixed portfolio of publicly traded equity securities of issuers named in their prospectus to exceed the 10% concentration restriction set out in section 2.1 of NI 81-102.
2. Investments in physical commodities
A closed-end fund would be prohibited from investing more than 10% of its NAV in physical commodities and specified derivatives with underlying interests in physical commodities. Closed-end funds that wish to focus on physical commodities or derivatives that provide exposure to physical commodities may choose to be "alternative funds" under the Alternative Funds Framework.
3. Investments in illiquid assets
A closed-end fund’s investment in illiquid assets must not exceed 10% of its NAV at the time the investment is made or 15% of its NAV at any time thereafter.
Under the CSA Proposal, a closed-end fund:
would be prohibited from borrowing cash in excess of 30% of its NAV;
would only be allowed to borrow cash from a "Canadian financial institution" (as defined in National Instrument 14-101 – Definitions); and
would only be allowed to create leverage through cash borrowings, not through the use of specified derivatives (as defined in NI 81-102) or short selling.
The CSA is considering whether a closed-end fund, under the Alternative Fund Framework, should be permitted to (i) borrow cash in excess of 30% of NAV and (ii) create leverage through the use of specified derivatives or short selling.
5. Investments in mortgages
Investments in mortgages by a closed-end fund would be restricted to guaranteed mortgages only (as defined in NI 81-102). A closed-end fund would be prohibited from investing in mortgages that are not fully and unconditionally guaranteed by a government or government agency (non-guaranteed mortgages).
Closed-end funds that are already invested in non-guaranteed mortgages would have 24 months after the CSA Proposal would come into effect to either:
- divest their holdings of non-guaranteed mortgages (which would trigger a change in the investment objectives if the fund's investment objectives state that the fund will be investing in non-guaranteed mortgages); or
- transition into the regulatory regime for issuers that are not investment funds.
6. Fund-of-fund structures
Closed-end funds would be:
- prohibited from investing in other closed-end funds; and
- permitted to invest in mutual funds in accordance with the current NI 81-102 requirements respecting "fund-of-fund" structures.
7. Securities lending, repurchases and reverse repurchases
Under the CSA Proposal:
- the framework currently applicable to securities lending, repurchases and reverse repurchases by mutual funds would be extended to apply to closed-end funds;
- the aggregate market value of securities loaned under securities lending transactions or sold in repurchase transactions by an investment fund may not exceed an amount equal to 50% of the fund's NAV; and
- closed-end funds may not include any borrowed cash (or portfolio assets purchased with borrowed cash) in calculating the maximum market value of their securities that may be loaned under securities lending transactions or sold in repurchase transactions.
According to the CSA, the impact of this proposed amendment would be minimal for mutual funds because:
- mutual funds are generally not permitted to be leveraged; and
- mutual fund liabilities are generally not significant relative to total assets.
1. Securityholder approval
Under the CSA Proposal, investment funds would require securityholder approval prior to implementing certain fundamental changes, including any change that would:
- convert a mutual fund into a closed-end fund;
- convert a closed-end fund into a mutual fund; and
- convert an investment fund into an issuer that is not an investment fund.
The investment fund may not pay for any of the costs and expenses related to the proposed fundamental change. Accordingly, the manager of the investment fund will bear the cost of holding the securityholder vote and will have to pay any filing fees required to commence continuous distribution, if applicable.
A closed-end fund that is structured from inception to convert to a mutual fund upon the occurrence of a specified event would be exempt from the proposed securityholder approval requirement described above, subject to certain disclosure and notice requirements.
Closed-end funds that do not list or trade their securities on a secondary market (often set up to facilitate tax-deferred "flow-through" share structures) would be exempt from the securityholder and regulatory approval requirements for fund mergers.
2. Proposed new conditions for pre-approved fund mergers
Under the CSA Proposal, a closed-end fund may merge with another investment fund without securityholder or regulatory approval if:
- it fulfils the conditions currently applicable to mutual funds in these situations under NI 81-102;
- it offers to redeem its securities at their NAV at a date that is before the effective date of the proposed merger; and
- the merger is effected at NAV.
3. Other operational requirements
Under the CSA Proposal:
- closed-end funds would be prohibited from making dilutive issuances;
- investment funds would be prohibited from issuing warrants, rights or other specified derivatives with underlying interests in a security of the investment fund; and
- closed-end funds that offer annual redemptions based on NAV or more regular redemptions at market value:
- must send investors an annual reminder of the procedures for exercising redemptions;
- must pay redemption proceeds no more than 15 business days after the redemption is effected; and
- must not redeem securities at an amount that is greater than the NAV of the security on the redemption date.
Closed-end funds would also be made subject to certain operational requirements currently applicable only to mutual funds, including NI 81-102 rules regarding custodians, incentive fees, commingling of cash and suspensions of redemptions.
Proposed 81-102 amendments that impact mutual funds
The CSA Proposal would also impact mutual funds in a number of ways:
- an exchange-traded mutual fund that is not in continuous distribution:
- would have to issue a news release if the fund intends to begin using specified derivatives, short selling and entering into securities lending, repurchases and reverse repurchases transactions;
- would no longer be permitted to bear any of the costs of incorporation, formation or initial organization of a mutual fund;
- would be prohibited from issuing a security for a price that is less than the NAV per security of that class; and
- would be required to pay redemption proceeds no more than 15 business days after the redemption is effected, unless the redemptions of the fund have been suspended in accordance with applicable requirements.
- the aggregate market value of securities loaned under securities lending transactions or sold in repurchase transactions by a mutual fund may not exceed an amount equal to 50% of the fund's NAV, rather than 50% of total assets, excluding the collateral delivered to the fund;
- securityholder approval would be required for a merger of a mutual fund with any issuer, not just with another mutual fund;
- securityholder approval would be required for a mutual fund to implement a change that restructures the fund into a non-redeemable investment fund or an issuer that is not an investment fund, and the fund would be prohibited from bearing the costs of the restructuring;
- the consideration offered to securityholders of an investment fund for a merger must have a value that is equal to the NAV of the fund if the merger is to be effected without prior securityholder or regulatory approval;
- all investment funds are prohibited from issuing warrants and similar instruments; and
- cash received in respect of sales and redemptions of all investment fund securities (and not only mutual fund securities) may be held in one trust account.
The CSA invites comment on a number of specific features of the CSA Proposal. Comments may be submitted until June 25, 2013.
*Modernization of Investment Fund Product Regulation (Phase 2): Proposed Amendments to National Instrument 81-102 Mutual Funds, Companion Policy 81-102CP Mutual Funds and Related Consequential Amendments and Other Matters Concerning National Instrument 81-104 Commodity Pools and Securities Lending, Repurchases and Reverse Repurchases by Investment Funds, March 27, 2013. Available online.