At the end of May 2011, the Canadian Securities Administrators issued CSA Staff Notice 81-322 Status Report on the Implementation of the Modernization of Investment Fund Product Regulation Project and Request for Comment on Phase 2 Proposals [available here]. The CSA Staff Notice follows on from the June 2010 publication of proposed amendments to National Instrument 81-102 Mutual Funds, which is described by the CSA as Phase 1 of the CSA’s overall two-part project to modernize public investment fund regulation. BLG’s Investment Management Bulletin Canadian Regulators Propose Modernized Rules for Mutual Funds: ETFs, Money Market Funds, Short Selling, Fund of Funds July 2010 describes the proposed amendments to NI 81-102 [Bulletin available here]. In the May 2011 Staff Notice, the CSA provide more details on the scope and timing of Phase 2 of the CSA’s modernization project, particularly as it relates to investment funds that are not conventional mutual funds, along with an update on the status of the amendments to NI 81-102 and the overall modernization project.
In connection with the proposals for Phase 2 of the modernization project, the CSA set out six specific broadly worded questions for comment in the Staff Notice. The comment period ends on July 25, 2011. In our view, rules that regulate ETFs and closed-end funds must take into account the features of these funds and the dynamics of the markets in which they are distributed. We intend to provide comments on the proposals, and we would be pleased to assist you in preparing your comments on the proposals.
Concurrent with the CSA’s modernization project, the Ontario Securities Commission is seeking applications from representatives from the investment fund industry to sit on its new Investment Fund Products Advisory Committee (IFPAC). The deadline for submitting an application is June 30, 2011. The IFPAC will consist of approximately 8 to 12 members, with the mandate of advising OSC staff specifically on emerging product developments and innovations occurring in the industry. This is a unique opportunity for industry participants to help shape the future of investment fund regulation. For more information, please see the OSC’s press release dated June 2, 2011 [available here].
THE CSA’S INVESTMENT FUND MODERNIZATION PROJECT – AT A GLANCE
PHASE 1 – PROPOSED AMENDMENTS TO NATIONAL INSTRUMENT 81-102 AND NATIONAL INSTRUMENT 81-106
These proposed amendments are intended to codify exemptive relief frequently granted by the CSA to mutual funds (including ETFs), as well as update the regulation of money market funds and were published for comment on June 25, 2010. The comment period ended on September 24, 2010. What to expect: The CSA expect to publish the amendments in final form by late summer 2011. The expected effective date for the amendments was not discussed in the Staff Notice.
PHASE 2 – REVIEW OF THE DIFFERENT REGULATORY REGIMES FOR DIFFERENT TYPES OF INVESTMENT FUNDS
The CSA’s objective for Phase 2 is to identify and address market efficiency, investor protection and fairness issues that arise out of the different regulatory regimes that apply to different types of publicly offered investment funds. Phase 2 is divided into two stages.
Stage 1: Closed-end Fund Regulation
During Stage 1 of Phase 2, the CSA propose to consider adopting certain core restrictions and operational requirements for closed-end funds similar to those governing mutual funds in NI 81-102. The CSA have identified the following as important principles: regulation of conflicts of interest and self-dealing, securityholder rights regarding fundamental changes and certain core investment restrictions. What to expect: The CSA expect to publish for comment a proposed new stand-alone rule for closed-end funds in early 2012.
Stage 2: Review of Investment Restrictions Applicable to Retail Mutual Funds and ETFs and Consideration of Further Requirements for Closed-end Funds
During Stage 2 of Phase 2, the CSA propose to re-examine the investment restrictions currently applicable to retail mutual funds and ETFs under Part 2 of NI 81-102 to assess whether, and what, changes should be made in recognition of market and product developments. The CSA indicate that they may also consider additional requirements or restrictions for closed-end funds during this stage. What to expect: The CSA expect to publish for comment any proposed amendments in 2013.
STATUS OF PHASE 1 – PROPOSED AMENDMENTS TO NI 81-102 – MUTUAL FUNDS AND ETFS
The CSA explain in the CSA Staff Notice that they anticipate publishing the June 2010 proposed amendments to NI 81-102 in final form by late summer 2011, subject to any material changes being made to the proposed amendments. In our view, this is a strong indication that the final amendments will be substantially the same as those proposed. While BLG along with others, in their comment letters, urged the CSA to consider making additional changes to NI 81-102 to address other substantive issues in NI 81-102 that the mutual fund industry and practitioners have had to grapple with over the years, it now appears unlikely that the CSA will include significant changes in the amendments. We will keep our clients informed about the amendments when they are published in final form, including advising as to the effective date of the amendments. We remind managers of money market funds that the proposed amendments contained fairly significant proposed amendments to the regime that applies to these funds, including proposed amendments about how a money market fund must calculate the average term to maturity of its portfolio, particularly when it invests in short-term floating rate securities, as well as its ability to invest in derivatives. Managers of money market funds may wish to review their portfolios now in anticipation of the changes which will likely come into force during 2011 or early 2012.
NEXT STEPS - PHASE 2 – STAGE 1 PROPOSALS – CLOSED END FUNDS
During Stage 1 of Phase 2, the CSA will consider adopting certain core restrictions and operational requirements for closed-end funds, similar to those already in place for conventional mutual funds. The CSA propose that the end result of Stage 1 of Phase 2 will be a new stand-alone rule that would apply to closed-end funds and which would be published for comment in early 2012. Examples of areas where the CSA will consider adopting additional rules include regulation of self-dealing, securityholder rights regarding fundamental changes and certain core investment restrictions. We believe that generally the adoption of rules and restrictions in the areas indicated by the CSA should not be controversial, particularly if those rules are largely principles-based; however, it will be very important for the CSA to not simply map over rules that apply to mutual funds without considering the fundamental differences between mutual funds and closed-end funds. There are significant economic and structural differences between these types of investment funds, including:
- Closed-end funds do not give their securityholders the right to “redeem on demand” (the regulators have generally interpreted this right as being a right to redeem at a frequency that is more than once a year). Closed-end funds therefore do not face the same pressures as mutual funds to maintain liquidity in their portfolio assets and accordingly the rules that relate to protections designed to enhance liquidity for mutual funds would not appear to be necessary.
- Closed-end funds are not in continuous distribution, which means that the portfolio manager of a closed-end fund in managing the fund’s assets does not have to deal with the same flow of assets as for mutual funds. Generally a closed-end fund is sufficiently scalable to achieve the fund’s investment objectives immediately after the closing of its initial public offering.
- After a primary distribution, closed-end funds are typically purchased on an exchange through an investment dealer. The level of sophistication expended to follow and analyze investments in closed-end funds, both by dealers and investors, is often greater than typical retail mutual funds.
- Closed-end funds are permitted to use leverage to enhance investor returns. In many cases, this levera ge is achieved through bank borrowings, with the closed-end fund providing a security interest over its other assets in favour of the lender.
- Securities of closed-end funds, after the primary distribution, are usually not traded at NAV, but ra ther trade on an exchange either at a premium or a discount to NAV. If the securities of a closed-end fund trade at a significant discount to the fund’s NAV for an extended period of time, the managers of closed-end funds can take corrective action, which may include converting to an open-end mutual fund.
The proposal to adopt certain core restrictions and operational requirements for closed-end funds does not come as a complete surprise. In the past year or so, CSA staff, in their review of prospectus filings for closed-end funds, have increasingly commented on a closed-end fund’s compliance with certain parts of NI 81-102 and expressed “staff’s expectation” about that compliance. OSC staff issued OSC Staff Notice 81-711 Closed-end Investment Fund Conversions to Open-end Mutual Funds in October 2010 [available here] which sets out the OSC’s expectations for a closed-end fund’s compliance with NI 81-102 if the fund is designed to convert at some point to an open-end mutual fund. Furthermore, we know that various international regulators, including the Securities and Exchange Commission in the United States, tend to regulate all investment funds in broadly similar ways, but often with nuances that reflect the different features of the various types of investment funds.
PHASE 2 – STAGE 2 PROPOSALS – CONVENTIONAL MUTUAL FUNDS, ETFS AND CLOSED END FUNDS
During Stage 2 of Phase 2, the CSA propose to focus on investment restrictions for conventional mutual funds and to assess what, if any, changes should be made to Part 2 of NI 81-102. As some of the issues that BLG and other commenters have pointed out to the CSA in connection with Phase 1 of the modernization project are issues with certain provisions in Part 2 of NI 81-102 (such as fund-on-funds restrictions and the rules on the use of specified derivatives), the hope is that the CSA will revisit these provisions during this stage. However, any changes in that regard will not be effective for some years yet, given that the CSA currently expect that any further proposed amendments to Part 2 of NI 81-102 will be published for comment no earlier than 2013.
The CSA indicate that they may also consider additional requirements or restrictions for closed-end funds at this stage. We query whether it would be more efficient and less disruptive for industry participants and investors for the CSA to consider investment restrictions for retail mutual funds, ETFs and closed-end funds all at the same time. In our view, the CSA’s proposal to consider certain “core investment restrictions” for closed-end funds as part of Phase 1 of Stage 2 should be deferred to Phase 2 of Stage 2.