Legal Updates

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Update

Monday, October 29, 2018

Background

On October 4, 2018, the Canadian Securities Administrators (the “CSA”) adopted amendments (collectively, the “Amendments”) to a number of national instruments governing the operation and offering of retail investment funds in Canada. Subject to ministerial approval requirements (which are not a guaranteed certainty these days), the Amendments will come into force on January 3, 2019.

The Amendments represent an important development for the investment fund industry, both for fund sponsors seeking new avenues to grow assets under management and for investment advisors struggling to provide investment options to their clients that are uncorrelated with traditional fixed income and equity markets.

The Amendments follow over five years of consultations by the CSA with investment fund industry stakeholders seeking to assess whether the existing regulatory framework sufficiently addressed product and market developments while ensuring sufficient levels of investor protection.The Amendments are the final instalment of the CSA’s Modernization of Investment Fund Product Regulation Project, which updates investment fund rules implemented in the early 2000s.  

Summary of Changes

1. “Alternative Mutual Fund” replaces the term “Commodity Pool” and any investment fund previously regulated as a commodity pool by National Instrument 81-104 – Commodity Pools (“NI 81-104”) must comply with the Amendments which are largely housed as changes to National Instrument 81-102 - Investment Funds (“NI 81-102”).

2. There has been considerable change in the investment restrictions applicable to mutual funds, alternative mutual funds and non-redeemable investment funds under the Amendments. In general, the investment restrictions for mutual funds have been liberalized, the investment restrictions for alternative mutual funds have been documented and the investment restrictions for non-redeemable investment funds have been narrowed. (See below under “Key Impacts”).

3. Alternative mutual funds will continue to need to limit their distribution through mutual fund dealers that can meet the heightened proficiency requirements set forth in NI 81-104 currently applicable only to commodity pools.  This requirement could materially narrow the investment advisors that can access these products for their clients.

4. The Amendments bring alternative mutual funds fully within the offering and continuous disclosure regime applicable to mutual funds. Certain additional information must be included in offering and continuous disclosure obligations to highlight that a particular fund is either an alternative mutual fund or a non-redeemable investment fund.

Key Impacts

1. Mutual Funds - With the liberalization of rules for mutual funds, retail investors and their advisors will shortly have some important new tools to diversify fixed income and equity portfolios better sheltering investors from historical volatility in traditional asset classes. The changes for mutual funds under the Amendments include codification of existing relief and expansion of the use of certain investment techniques. For example, mutual funds will be permitted to invest up to 10% of their net assets in an alternative mutual fund or a non-redeemable investment fund, which is also governed by NI 81-102.

2. Alternative Mutual Funds - Even greater latitude to engage in certain portfolio techniques and asset classes will exist for alternative mutual funds to those that will apply to mutual funds. For example, alternative mutual funds may invest up to 20% of their net assets in securities of a single issuer (versus 10% for a mutual fund). In addition, alternative mutual funds may invest up to 100% of net assets in another investment fund subject to NI 81-102. Pursuant to section 2.6(2) NI 81-102, alternative mutual funds may borrow cash up to a limit of 50% of their net assets for investment purposes. Subject to certain limits, alternative mutual funds may sell short securities with a market value of 50% of net assets, which is an increase from 20% of net assets that mutual funds, including commodity pools, may currently undertake. An alternative mutual fund may have aggregate exposure to cash borrowing, short selling and specified derivatives of 300% of the net assets of the fund. In particular, section 2.9.1 of NI 81-102 provides:

“For the purposes of subsection (1) [the cap], an alternative mutual fund or non-redeemable investment fund’s aggregate gross indebtedness is the sum of the following, divided by the fund’s net asset value:

  • (a) The aggregate value of the alternative mutual fund’s or non-redeemable investment fund’s outstanding indebtedness under any borrowing agreements for which subsection 2.6(2) applies;
  • (b) The aggregate market value of all securities sold short by the alternative mutual fund or non-redeemable investment fund as permitted by section 2.6.1; and
  • (c) The aggregate notional value of the alternative mutual fund’s or non-redeemable investment fund’s specified derivatives positions, minus the aggregate notional amount of the specified derivative positions that are hedging transactions.”

This aggregate limit received significant commentary from the investment fund industry and it is helpful that the CSA agreed to introduce the aggregate notional value for specified derivative positions that are for hedging transactions. Notably, the very broad definition of “hedging” for the purposes of NI 81-102 has remained intact. This will have an important impact in permitting a number of fixed income and equity arbitrage strategies to be available to retail investors. Finally, alternative mutual funds may not invest more than 10% of net assets in “illiquid assets”—the current level applicable to mutual funds.

3. Non-redeemable investment funds - The CSA have extended virtually all of the investment restrictions applicable to alternative mutual funds to non-redeemable investment funds rather than permitting non-redeemable investment fund products to flourish by allowing fund sponsors and investment banking professionals to develop new asset classes and investment techniques unfettered by regulation of investment techniques as was urged by many in the industry. Most importantly, the aggregate cap on borrowing, short selling and specified derivatives will mean that product innovation will need to occur through exempt investment fund and public non-investment fund offerings, only some of which will be available to retail investors. This is arguably the most disappointing development arising from the Amendments.

Next Steps

At least six fund sponsors have made filings of a preliminary prospectus for one or more alternative mutual funds. A number of other fund sponsors are rumoured to be launching offerings shortly. If an alternative mutual fund offering is seeking to file a final prospectus prior to January 3, 2019, an exemptive relief application (and related filing fee) must be made. CSA Staff have advised that fund sponsors can expect exemptive relief to be granted by the CSA if the form of the requested relief is identical to the Amendments.

Another closely scrutinized area is the transitional provisions under the Amendments. Since the Amendments purport to limit the operations of certain non-redeemable investment funds already in existence, the intent and scope of section 1.2(5) of NI 81-102 will be critical in the coming months. It provides:

“Despite paragraph 1(a.1), the following provisions do not apply to a non-redeemable investment fund that was established before October 4, 2018, unless the fund has filed a prospectus for which a receipt was issued after that date:

  • (a) Sections 2.1 and 2.4;
  • (b) Paragraphs 2.6(1)(a), (b) and (c), and subsection 2.6(2), and
  • (c) Sections 2.6.1 [short sales], 2.6.2 [total borrowing and short sales] and 2.9.1 [total borrowing, short selling and specified derivatives].”

Currently, successful non-redeemable investment funds that are able to access the marketplace will offer additional securities by way of a long form prospectus, short form prospectus or pricing supplement to a shelf prospectus. It is not clear why the transitional rules prohibit future offerings by well-established non-redeemable investment funds utilizing certain of these funding arrangements.

Conclusion

After five years of CSA consultation with stakeholders in the investment funds industry, retail investors will finally have some investment products broadly available that will assist them in protecting their savings from future fixed income and equity market downturns. It is hoped that the CSA will be open to “tweaks” to the Amendments as the investment fund industry proves over time that it is able to provide well-constructed, well-disclosed alternative mutual fund products. For example, if investment fund portfolios operate under the current regulatory regime (as amended by the Amendments) and provide excellent risk/reward results in uneven markets, it is hoped that investment restrictions for either or both alternative mutual funds and non-redeemable investment funds could be further liberalized.

If you have any questions with respect to the matters discussed above, please contact Ron Schwass by email at rschwass@wildlaw.ca, Geoffrey Cher by email at gcher@wildlaw.ca, Nick Gray by email at ngray@wildlaw.ca or any other member of our Structured Finance practice group.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.