On June 19, 2014, the Canadian Securities Administrators (CSA) published the final instalment of the amendments (Amendments) to National Instrument 81-102 (NI 81-102) and the Companion Policy 81-102 CP (CP) (and consequential amendments to other instruments) bringing to an end stage one of Phase 2 of the CSA’s Modernization of Investment Fund Product Regulation Project (Modernization Project). The key components of the Amendments, first published for comment on March 27, 2013 (2013 Proposals), introduce core operational requirements and fundamental investment restrictions for closed-end funds (CEFs). Subject to transition and grandfathering provisions noted below, the Amendments will come into force on September 22, 2014.
CORE OPERATIONAL REQUIREMENTS
The Amendments will extend certain “core” operational requirements, specifically, the Conflict of Interest Provisions (Part 4 of NI 81-102), Securityholder and Regulatory Approval Requirements for Fundamental Changes (Part 5 of NI 81-102) and Custodianship Requirements (Part 6 of NI 81-102) to CEFs. These changes were broadly supported by the industry in its responses to the 2013 Proposals and, given that these requirements typically already appear in CEFs’ constating documents, will have little effect on the day-to-day operations of most CEFs.
The principal remaining operational amendments, including those relating to Redemptions (Part 10 of NI 81-102), Co-mingling of Cash (Part 11 of NI 81-102), Record Date (Part 14 of NI 81-102) and Securityholder Records (Part 13 of NI 81-102), were also generally applied and adhered to by most CEFs in the market, and accordingly, their adoption should have no practical effect on the day-to-day operations of CEFs.
FUNDAMENTAL INVESTMENT RESTRICTIONS
The CSA adopted an investment restriction to limit a CEF’s investment in any one issuer to 10% of the issuer’s outstanding voting or equity securities. This amendment is said to be consistent with the “fundamental characteristics of investment funds,” which is that a fund should not become actively involved in the management of its investee issuers. This change should have little effect on most CEFs as this restriction already appears in the constating documents of most CEFs.
With the introduction of paragraph 2.3(2)(c) of NI 81-102, the Amendments will prohibit CEFs from acquiring certain loan syndications or participations. This restriction will only apply where the purchase would require the CEF to assume responsibilities in administering the loan in relation to the borrower. Here again the CSA are of the view that those types of activities would not be consistent with the fundamental characteristics of publicly offered investment funds. This view has been long held by advisers to the industry, and accordingly, the Amendment will have no practical effect on the management of most CEFs.
Investments in Mortgages
New paragraph 2.3(2)(b) of NI 81-102 will prohibit CEFs from investing in mortgages, other than guaranteed mortgages. The CSA suggest that investing in mortgages may be akin to engaging in a lending business, which is generally outside the scope of portfolio management typically engaged in by publicly offered investment funds. Therefore, entities that wish to invest in mortgages will generally not be regulated as investment funds. However, CEFs that filed a prospectus before September 22, 2014, will be grandfathered, and no conversion/transition out of the investment fund regulatory regime will be required. Whether these entities will be able to complete follow-on offerings without first converting to a corporate issuer is unclear as, in their commentary, the CSA suggest that they would take that opportunity to re-engage the CEF in a discussion as to whether the issuer operates in a manner consistent with the fundamental characteristics of an investment fund.
Fund of Funds
CEFs will be permitted to invest in other investment funds provided that the investee fund is subject to, or complies with the provisions of, NI 81-102 and is a reporting issuer in at least one Canadian jurisdiction in which the CEF is a reporting issuer. This section would preclude the investment by CEFs in private investment funds that by their nature do not operate in compliance with NI 81-102. However, this section would not preclude investment in private equity funds or other entities that are not subject to regulation as investment funds.
In addition, NI 81-102 has been amended to clarify that a mutual fund is not permitted to invest in a CEF. For mutual funds that currently invest in CEFs, the CSA will consider exemptive relief on a case-by-case basis.
ALTERNATIVE FUNDS FRAMEWORK
Other than the investment restrictions noted above, the CSA have elected to defer consideration of investment restrictions for CEFs until the next stage of the Modernization Project, which will involve the redesign of National Instrument 81-104 to create a more comprehensive framework for what the regulators are referring to as “alternative funds” (Alternative Funds Framework). At this stage, the Alternative Funds Framework remains highly conceptual, and accordingly, it is unclear just how problematic its implementation will be for CEFs.
No timetable has been given for the development of the Alternative Funds Framework. Importantly, the CSA telegraphed that they would consider grandfathering with respect to new investment restrictions that are imposed under the Alternative Funds Framework.
The proposed investment restrictions on CEFs/alternative funds noted in the 2013 Proposals that have been deferred include:
- A concentration restriction that would permit a CEF to invest a larger percentage of its net asset value (NAV) in the securities of a single issuer than is permitted under NI 81-102
- A limit that would cap the borrowing of cash at 50% of NAV of the CEF
- A short-selling rule that would cap short exposure to any one issuer to 10% of NAV of the CEF and aggregate short exposure to 40% of NAV of the CEF, each calculated at the time of the short sale (and a related provision would exempt the CEF from a requirement to hold cash cover pursuant to NI 81-102)
- A leverage limit (aggregating leverage employed by underlying funds) of 3:1 to be observed at all times
WARRANT AND RIGHTS OFFERINGS
The CSA adopted changes to Part 9 of NI 81-102 that deal with the sale of securities subsequent to a CEF’s initial public offering. These changes preclude the issuance of rights, warrants or other securities exercisable into securities of the fund. While this type of offering was being used less frequently, many managers, with the approval of their IRCs felt that there were circumstances where the benefits associated with improved liquidity and reduced management expense ratios outweighed the potential dilution that can result from these offerings. The CSA are of the view that the potential harm to securityholders by such dilution “generally” outweighs any benefit of such offerings. However, in their commentary on the industry responses to the 2013 Proposals, the CSA suggest that, in limited and exceptional circumstances, the CSA may consider applications for exemptive relief if a CEF can demonstrate market necessity and where steps are taken to mitigate any potential dilution and conflicts of interest for the CEF so that the benefits of the offering outweigh any costs of dilution.
PRICING OF FOLLOW-ON OFFERINGS
The CSA introduced section 9.3(2) of NI 81-102 to address dilution arising in connection with the issuance of securities by CEFs following their initial public offering by imposing minimum requirements on the issue price of such securities. While it appears to propose two tests that would need to be met in connection with the pricing of follow-on offerings, the CP suggests that market practice (which requires that the issue price be set so as to avoid dilution based on the prevailing NAV at the time the price is set) will satisfy the concerns underpinning this Amendment.
The Amendments will require that the manager bear the cost of the conversion of a CEF to an open-end fund in all circumstances, even if that change is disclosed in a CEF’s prospectus. The Amendments will also require securityholder approval for a conversion, even if the conversion has been disclosed in the CEF’s prospectus on the theory that securityholders should have a vote on fundamental changes no matter how they are effected. The CSA also note that requiring a securityholder vote on a conversion will mitigate the potential for regulatory arbitrage associated with converting a CEF to a mutual fund within a short period of time following its launch.
SECURITIES LENDING AND REPURCHASE TRANSACTIONS
The securities lending and repurchase transaction provisions applicable to public mutual funds will be extended to CEFs beginning on September 21, 2015. Consequently, in order to lend out portfolio securities or enter into repo transactions, a CEF will be required from that date to (1) retain its custodian or a sub-custodian to act as its securities lending or repo agent pursuant to a written agreement covering prescribed matters, (2) ensure that permitted collateral or cash in the prescribed amounts to eliminate counterparty credit risk is received in respect of each transaction, (3) not reinvest or reuse collateral or cash received from counterparties other than in permitted short-term investments or transactions, (4) ensure that a written agreement governing each transaction implements the requirements set out in the applicable sections of NI 81-102, (5) establish controls and policies (including in respect of permitted counterparties) and maintain records in accordance with Section 2.16 of NI 81-102, and (6) issue a press release and provide the required notice to investors of the commencement of the relevant securities lending or repo activities if prescribed disclosure has not been included in all prior prospectuses of the fund.
In addition, the total amount of securities that may be loaned out or sold by a CEF under all outstanding securities loans and repo transactions may not exceed 50% of the NAV of the CEF. Funds with forward agreements will be particularly affected since these funds typically hold a basket of Canadian securities that is available for lending to offset the cost of the forward transaction typically with minimal increased credit exposure for investors. The limitation on securities lending will impact the cost of these arrangements beginning on September 21, 2015, when all of the Amendments related to securities lending and repo transactions come into force. Given the fact that securities loans are fully collateralized, this 50% cap on lending is a conservative approach. Interestingly, due to the fact that the Amendments now provide that the 50% cap applies based on the NAV of the fund as opposed to the “total assets” of the fund, it would be possible where the CEF’s NAV increases significantly as compared to the value of the Canadian share basket, to lend out 100% of the shares comprising the share basket.
Furthermore, in addition to disclosure currently required regarding the value of securities loaned out and collateral held by an investment fund, the Amendments provide that additional disclosure is required to be given regarding persons entitled to receive payments in connection with securities lending transactions and the amounts of these payments.
The matter of who must bear offering expenses, which was not described in CSA Staff Notice 81-322 that introduced Phase 2 of the Modernization Project in May 2011, has been deferred and its scope significantly scaled back from the blanket application reflected in the 2013 Proposals. Motivated by concerns relating to “regulatory arbitrage,” the CSA suggest that, concurrently with publishing the Alternative Funds Framework, they may address the matter of offering expenses in connection with CEFs that convert to mutual funds after a “short period.”
While the CSA have elected to defer the discussion of limits on illiquid assets, including the definition of illiquid assets, the CSA have added commentary in the CP that reflects their concern with respect to these types of assets. The CP recommends the establishment of a risk management policy that considers appropriate limits on illiquid assets that includes procedures by which the CEF will measure, monitor and manage liquidity. Given that the CSA are of the view that illiquid assets are more difficult to value, CEFs that hold significant quantities of illiquid assets should expect comments and questions relating to these issues going forward.
BACKGROUND TO THE MODERNIZATION PROJECT
The Modernization Project is a fundamental rethink by the CSA of the regulation of publicly offered investment funds. Pursuant to the Modernization Project, the CSA are considering whether the current regulatory approach sufficiently addresses product and market developments in the Canadian investment fund industry and continues to adequately protect investors.
Phase 1 of the Modernization Project focused primarily on publicly offered mutual funds and was completed when amendments to NI 81-102 came into force in April and October 2012. Specifically, the Phase 1 amendments (1) codified certain types of exemptive relief frequently granted in recognition of market and product developments, such as allowing mutual funds to engage in short selling subject to certain standard restrictions, (2) expanded the types of “cash cover” that mutual funds could hold in compliance with anti-leverage investment restrictions, and (3) introduced new provisions to address the unique features of ETFs. The Phase 1 amendments are described in our February 2012 Blakes Bulletin: CSA to Complete Phase 1 of Modernization Project and Amend Investment Fund Rules.
In May 2011, the CSA published 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 (CSA Staff Notice 81-322), which, among other things, provided greater details on the scope and timing of Phase 2 of the Modernization Project. The main objective of the Phase 2 proposals was to address the issues that arise out of the different regulatory regimes that apply to different types of publicly offered investment funds.
On March 27, 2013, the CSA published for comment proposed amendments to securities rules governing investment funds. The 2013 Proposals comprised stage one of Phase 2 of the Modernization Project.