The long-anticipated changes to the registration regime under Canada’s securities regulation have now been finalized with the release of National Instrument 31-103 Registration Requirements and Exemptions on July 17, 2009. Touted by the media as a hedge fund rule, National Instrument 31-103 is considerably more far-reaching in scope and effect. Managers of hedge funds1 are just one group of securities industry market participants that will be affected by the new registration regime.
The new registration regime will become effective on September 28, 2009 (subject to government approvals) and anyone applying for registration in any category on or after that date will need to comply with the new requirements. Industry participants already registered on September 28, 2009 will be expected to comply with the new regime, but will be given additional time to achieve compliance with some of the new requirements. Our July 2009 Investment Management Advisory entitled Canadian Securities Regulators Release Final Registration Rule [available here] outlines the scope of National Instrument 31-103, as well as provides an overview of the key changes (from the last published version) made by the Canadian securities regulators (CSA) in finalizing the various instruments.
Although the CSA indicate that they have made no “material” changes to the final version of National Instrument 31-103 (from the previously published draft which would have necessitated an additional comment period), the devil is in the details, and many of the details have been tweaked. As well, transitional provisions for meeting the new registration, proficiency, capital and insurance requirements have now been provided. This Investment Management Advisory summarizes the impact that National Instrument 31-103 will have on the hedge fund industry and the timelines for implementation of the new requirements.
National Instrument 31-103 expands and further clarifies existing regulation of hedge fund managers, advisers (portfolio managers) and distributors by
- Introducing a new category of registration for “investment fund managers”
- Introducing the registration category of “exempt market dealer” across Canada, except in certain provinces and the territories where exemptions will be available for purely “local” market participants
- Introducing the “business trigger” test for dealers for determining when registration is required
- Increasing capital and insurance requirements for some categories of registration
- Changing proficiency requirements for individual registrants
- Enhancing compliance and supervisory expectations
- Governing referral arrangements
- Requiring specific client complaint handling procedures, including dispute resolution
- Changes in financial reporting requirements.
At the same time, National Instrument 31-103 eliminates the registration requirement for non-Canadian advisers and dealers who provide services to certain institutions and ultra-high net worth individuals, provided specified conditions are followed.
There will be some grandfathering of individuals registered under the current regime. Transitional provisions give existing registrants and unregistered market participants as much as two years to comply with certain provisions of National Instrument 31-103. New market participants starting operations after September 28, 2009 will not benefit from these transitional rules.
Registration of Investment Fund Managers – The new registration category of “investment fund manager” will apply to Canadian managers of all investment funds, including hedge funds and retail mutual funds. Individuals who act as the investment fund manager’s chief compliance officer and ultimate designated person must also register.
“Investment fund manager” is defined in applicable securities regulation as “a person or company that directs the business, operations or affairs of an investment fund”. The term “investment fund” includes all redeemable mutual funds and non-redeemable investment funds, whether established as a corporation, trust or limited partnership, formed for the purpose of pooling investors’ money in order to make investments in securities. This category of registration will capture, for example, general partners of hedge funds organized as limited partnerships unless they delegate management duties to a registered investment fund manager. “Pure” private equity fund managers, whose mandate is to exercise control over or to participate in management of investee companies, are not intended to be caught by this registration requirement.
Capital, insurance, and operational requirements apply to an investment fund manager, and proficiency requirements apply to its chief compliance officer, but an investment fund manager that is active on September 28, 2009, will have the benefit of transitional provisions, as discussed below.
An investment fund manager will be required to register in the province or territory where its head office is located, but if it is active as of September 28, 2009, it will have a one year transition period (to September 28, 2010) in which to apply for registration in that province or territory. An investment fund manager will have a two-year transition period (to September 28, 2011) in which to apply for registration in each of the other provinces and territories where it has operations. Similarly, investment fund managers that do not have a head office in Canada will not have to be registered under National Instrument 31-103 for at least two years, but may still be required to pay market participation fees in Ontario. During this two-year transition period, the CSA expect to publish for comment amendments to National Instrument 31-103 that will outline whether and where investment fund managers will be required to register in addition to the province or territory where their head office is located.
Registration of Exempt Market Dealers – National Instrument 31-103 introduces a new registration category for dealers - “exempt market dealer” - that will replace the “limited market dealer” (LMD) category in Ontario and Newfoundland and Labrador and will apply across Canada. Hedge fund managers will have to register as an exempt market dealer in every province and territory where they wish to market and sell their funds, unless they engage a dealer that is registered in the prospective purchaser’s province or territory. Each officer and employee of a registered exempt market dealer that carries out the trading activities for the firm, and the firm’s chief compliance officer and ultimate designated person, must also be registered.
Firms and individuals resident in Alberta, British Columbia, Manitoba, the Northwest Territories, Nunavut and the Yukon Territory, and possibly Saskatchewan, may be exempted from the exempt market dealer registration requirement, but only in very limited circumstances, including where they are not registered in any other category anywhere in Canada. Unlike LMDs, a registered exempt market dealer will be subject to minimum capital and
insurance as well as proficiency requirements for its dealing representatives and its chief compliance officer. Exempt market dealers will be subject to know-your-client and suitability requirements, except in respect of trades to permitted clients who waive those requirements. “Permitted clients” include certain institutional investors such as banks and trust companies, government agencies, pension plans, registrants, advisers acting on behalf of managed accounts, investment funds managed or advised by a registrant, individuals with more than $5 million in financial assets and companies with net assets of at least $25 million.
Existing registered LMDs will automatically be converted to the new exempt market dealer category and, although there will be a transition period before the new capital, insurance and proficiency requirements must be met, those firms will have to comply with many of the new provisions aimed at prudent business practice, as soon as National Instrument 31-103 comes into force.
Registration of Portfolio Managers – National Instrument 31-103 will continue the current regime of requiring all advisers to register in each province and territory where they provide advice, but in one of only two categories: portfolio manager or restricted portfolio manager. In this context, “advisers” are persons who engage in, or hold themselves out as engaging in, the business of advising others as to the investing in or buying or selling of securities. Portfolio managers will not be limited as to their advising activities. Some provinces, such as Québec and Ontario, will continue to maintain a parallel regulatory regime for advising and trading in exchange-traded commodities and futures, and separate registration will be required for those activities. As the name suggests, restricted portfolio managers will be subject to conditions of registration that limit their advising activities (for example, they may be limited to advising in respect of a specific type of security or in respect of securities of issuers within a specific industry). Officers and employees of a registered adviser that carry out the advising activities, as well as the chief compliance officer and ultimate designated person of the firm, must be registered. There are capital, insurance, proficiency and conduct requirements for advisers under National Instrument 31-103, in many instances with higher thresholds than under existing regulations.
Permitted Individuals – Although not required to “register”, directors and senior officers of a registrant firm that do not themselves conduct registrable activities must nonetheless provide information to the regulators as “permitted individuals”, but the universe of individuals required to be designated as “permitted individuals” is smaller under the new registration regime than before.
Registration Requirements and the “Business Trigger” – Only advisers and dealers that are “in the business” of advising or trading will be required to register. As a result, many firms currently registered as LMDs, for example, only because their activities fall within a very broad definition of “trading”, may not be required to register under National Instrument 31-103. To determine whether a particular firm or individual is “in the business”, the regulators will look at factors such as whether the firm is paid for its activities, whether the firm is acting as an intermediary and whether the firm or individuals actively solicit clients. There is no such business trigger test for investment fund managers. Firms that act as investment fund managers must register.
Capital and Insurance Requirements – The new capital and insurance requirements of National Instrument 31-103 are certain to have a significant impact on many hedge fund industry participants. Minimum capital required for investment fund managers will be $100,000; for dealers $50,000; and for portfolio managers $25,000. Minimum working capital will be adjusted upward to reflect deductibles under required insurance policies, guarantees provided by the firm, unresolved differences (for example disputed settlements of purchase or sales of securities) and margin rates on securities owned by the firm and counted as current assets. For firms registered in more than one category, these minimums are not cumulative. Existing registrants will have a one-year transition period before being required to meet the increased capital requirements.
Insurance or bonding requirements will also increase for firms with significant assets or assets under management, based on a formula, from a minimum of $50,000 to as much as $25,000,000. National Instrument 31-103 specifies the types and level of insurance or bonding required. Existing regisrants will have a six-month transition period before being required to meet the new insurance requirements.
Proficiency Requirements – Dealing representatives of exempt market dealers will be required to have passed the Canadian Securities Course Exam (or the equivalent U.S. courses), the Exempt Market Products Exam (which is new), or meet the requirements of an advising representative of a portfolio manager. Chief compliance officers for registrant firms must meet specified educational and experience requirements (for example, a lawyer or accountant would qualify if they passed the Canadian Securities Course Exam and the PDO Exam and had 36 months of relevant experience in the industry). Advising representatives of a portfolio manager will qualify with a full CFA charter and one year of relevant experience, or the Canadian Investment Management designation and four years of relevant experience, which appears at first blush to ease the current requirements. An individual can be registered as an associate advising representative with the Canadian Investment Management designation or Level 1 of the CFA program, plus 24 months of relevant experience, but an individual with only Level 1 of the CFA program will no longer be upgraded to full advising representative status merely with the passage of time. An advising representative may be designated as the chief compliance officer of a portfolio manager if he or she has passed the PDO Exam.
Compliance – National Instrument 31-103 emphasizes that compliance is not the sole responsibility of the ultimate designated person or the chief compliance officer but that compliance is a firm-wide responsibility. A registered firm will be required to establish and enforce a system of controls and supervision that ensures the firm’s compliance with all applicable requirements and that manages the risks to which the business is subject. This system of controls must be documented in the form of written policies and procedures. The registered firm will also be required to ensure that its compliance monitoring and supervision policies and procedures take into account conflicts of interest management issues. Some exemptions from these compliance rules are available to registrants that deal with permitted clients, but only in very limited circumstances.
Delegation – National Instrument 31-103 recognizes that many fund management duties, for example back office administration, are delegated to third party service providers. All registrant firms will be required to conduct appropriate due diligence on all such service providers and to regularly monitor their activities. Ultimate responsibility for the actions of the service providers will remain with the registrant.
Referral Arrangements – National Instrument 31-103 codifies current CSA policies and suggested best practices regarding referral arrangements. All such arrangements will have to be in writing and clearly allocate responsibility for discharging regulatory duties, such as know-your-client and suitability requirements. Registrants will have to ensure that investors are fully informed of all such arrangements and payments made under them.
Financial Reporting – National Instrument 31-103 will require all registrants to file annual audited financial statements and required forms with the regulators. Certain dealers and investment fund managers must also file quarterly unaudited statements. Investment fund managers will also be required to file, annually and quarterly, a description of any net asset value adjustments made in the period. All registrants will be required to immediately report any shortfall in minimum regulatory capital. The CSA propose to require all registrants who are not members of an SRO to prepare financial statements in accordance with International Financial Reporting Standards as of January 1, 2011.
Grandfathering and Transitional Provisions – There are grandfathering and transitional provisions in National Instrument 31-103 for existing registrants and market participants who will be subject to the new rule.
For example, a hedge fund manager in Ontario that is currently registered as an IC/PM and LMD in Ontario, and that wants to make units of its funds available for direct purchase throughout Canada, will be required to register under National Instrument 31-103 as an investment fund manager and portfolio manager in Ontario and as an exempt market dealer in every province and territory where the fund is marketed and sold. It will also be required to meet all requirements of National Instrument 31-103 applicable to those categories of registration, but with the benefit of the following transitional provisions.
- The firm will automatically be registered as a portfolio manager and exempt market dealer in Ontario as of September 28, 2009 when National Instrument 31-103 comes into force
- The firm will have one year (to September 28, 2010) to apply for registration as an exempt market dealer in the other provinces and territories where the fund is directly marketed and sold
- The firm will have one year (to September 28, 2010) to apply for registration as an investment fund manager in Ontario
- Individuals within the firm that are currently registered as advising officers or representatives will automatically be registered as advising representatives under the new regime and will not have to meet the new proficiency requirements of National Instrument 31-103 so long as they remain so registered
- Individuals within the firm that are currently registered as trading officers or representatives under the LMD registration will automatically be registered as dealing representatives under the new regime and will have one year (to September 28, 2010) to meet the proficiency requirements of a dealing representative of an exempt market dealer
- The firm will have three months (to December 28, 2009) to designate and apply for registration of an ultimate designated person
- The firm will have three months (to December 28, 2009) to designate and apply for registration of a chief compliance officer, and if the individual so designated was already identified to the Ontario Securities Commission (OSC) as the compliance officer of the firm on the date National Instrument 31-103 comes into force, then so long as that person continues to act as the firm’s chief compliance officer, he or she need not meet the proficiency requirements of National Instrument 31-103 for a chief compliance officer of a portfolio manager and exempt market dealer. However, that person must meet the proficiency requirements of a chief compliance officer for an investment fund manager once the firm applies for registration in that category (deadline for application – September 28, 2010)
- The firm will have one year (to September 28, 2010) to meet the new capital requirements for a portfolio manager and exempt market dealer, and will have to meet the capital requirements of an investment fund manager once the firm applies for registration in that category (deadline for application – September 28, 2010)
- The firm will have six months (to March 28, 2010) to ensure that all of its referral arrangements (both existing and new) meet the requirements of National Instrument 31-103
- The firm will have two years (to September 28, 2011) to make available to its clients a dispute resolution or mediation service in accordance with National Instrument 31-103.