On September 22, 2016, the Canadian Securities Administrators (the “CSA”) published their long-awaited proposal for a “liquid alternatives” regulatory framework in Canada (the “Proposal”). The Proposal primarily involves amendments to the rules contained in National Instrument 81-102 Investment Funds (“NI 81-102”) currently applicable to conventional mutual funds and non-redeemable investment funds. The new framework would create a new category of prospectus offered investment funds called “alternative funds” that would be able to use investment strategies that are not permitted to be used by conventional mutual funds.
Currently, alternative strategies are generally only available through private pooled funds offered under offering memorandums to “accredited investors” and other exempt purchasers. The Proposal has the potential to advance a significant change in the industry, as “alternative funds” would be able to distribute their securities on a continuous basis to retail investors under a simplified prospectus.
The Proposal also eliminates National Instrument 81-104 Commodity Pools (“NI 81-104”), currently applicable to publicly offered commodity pools, and subsumes that regime into the new category of “alternative funds” in NI 81-102. The proposed amendments recognize that the commodity pool rules have generally not been used for funds that are “commodity pools” in the traditional sense. Rather, many commodity pools that operate under NI 81-104 that employ derivative strategies not permitted to be used by conventional mutual funds under NI 81-102.
The Proposal also modifies certain investment restrictions for both conventional mutual funds and non-redeemable investment funds or closed-end funds. These changes were considered to be interrelated with the alterative funds framework. In many cases, the new investment restrictions introduced for alternative funds are also being imposed on closed-end funds where such restrictions do not currently exist.
The Proposal is part of the CSA’s broader project over the past few years to modernize investment fund product regulation. In 2012, Phase 1 of the modernization project codified certain exemptive relief that had frequently been granted to publicly offered mutual funds in recognition of market and product developments. In 2014, Phase 2 of the project introduced core investment restrictions and fundamental operational requirements for closed-end funds and enhanced disclosure requirements for all investment funds regarding securities lending activities. The Proposal represents the last part of Phase 2 and the final stage of the CSA’s modernization project.
The CSA first published an outline of a proposed regulatory framework for alternative funds over three years ago. Two years later, in February 2015, they published a summary of the feedback received and noted that publication of the proposed amendments would follow in due course. Following some delays, the Proposal is finally here, with the CSA seeking comments on a number of questions by December 22, 2016.
Summary of the Alternative Funds Proposal
The following is a summary of the principal characteristics and restrictions of the alternative funds framework under the Proposal:
Naming and definition of an “Alternative Fund”
The name of an alternative fund is not required to contain the word “alternative” or any other word signalling that the fund is an alternative fund under NI 81-102.
An “alternative fund” is defined as “a mutual fund that has adopted fundamental investment objectives that permit it to invest in asset classes or adopt investment strategies that are otherwise prohibited but for prescribed exemptions from Part 2 of NI 81-102.” The definition of “alternative fund” is similar to the current definition of “commodity pool” in NI 81-104, which is “a mutual fund, other than a precious metals fund, that has adopted fundamental investment objectives that permit it to use or invest in (a) specified derivatives in a manner that is not permitted by NI 81-102, or (b) physical commodities in a manner that is not permitted by NI 81-102.”
Investments by alternative funds in any one issuer can be no more than 20% of net asset value (NAV) of the fund at the time of purchase (in comparison to 10% for conventional mutual funds). This 20% concentration limit does not apply to the purchase of certain securities, including government securities.
Closed-end funds, which currently have no concentration restrictions, would also be subject to this 20% limit under the Proposal.
Alternative funds would be exempt from any restrictions relating to investments in physical commodities. Closed-end funds would also continue to be exempt from such restrictions.
Under the proposal, conventional mutual funds, which are currently restricted to investing in gold, would be permitted to directly invest in gold, silver, palladium and platinum as well as to obtain indirect exposure to any physical commodity through specified derivatives.
Investments in illiquid assets are limited to 10% of NAV after purchase and 15% of NAV at any time. This same rule currently applies to conventional mutual funds. The CSA recognizes that certain types of alternative funds may wish to hold a larger percentage of their portfolio in illiquid assets (and consequently offer less frequent redemptions) and is seeking feedback on whether a higher illiquid asset limit would be appropriate in such circumstances.
The Proposal also introduces different illiquidity restrictions for closed-end funds, which currently have no such restrictions. Under the Proposal, illiquid assets of closed-end fund would be limited to 20% of NAV after purchase and 25% of NAV at any time. This may be a significant change for some funds that have a particular focus on illiquid assets.
The Proposal makes no substantive change to the definition of “illiquid assets”, which may not capture certain assets that may be of interest to alternative fund managers.
Alternative funds can borrow up to an amount equal to 50% of their NAV. Although, they may only borrow from entities that qualify as investment fund custodians under section 6.2 of NI 81-102, which essentially restricts borrowing to banks and trust companies in Canada (or their qualified dealer affiliates). Where the lender is an affiliate of the alternative fund’s investment manager, approval of the fund’s independent review committee (“IRC”) would be required under National Instrument 81-107 Independent Review Committee for Investment Funds (“NI 81-107”). In addition, the Proposal specifies that any borrowing agreements entered into must be in accordance with normal industry practice and be on standard commercial terms for agreements of this nature. Closed-end funds, which currently have no such borrowing restrictions, would also be subject to all of the borrowing restrictions applicable to alternative funds.
Physical short selling is viewed by the CSA as another form of borrowing. Alternative funds can short sell securities up to an amount equal to 50% of their NAV (in comparison to 20% for conventional mutual funds and, subject to obtaining exemptive relief, 40% for commodity pools). In addition, in order to facilitate long/short strategies, alternative funds will not be required to have cash cover for their short positions (in comparison conventional mutual funds are subject to a 150% cash cover requirement).
An alternative fund is also limited to selling short securities of single issuer that represents more than 10% of NAV (in comparison to 5% for conventional mutual funds). In contrast to the concentration limits of 20% for the purchase of securities, which does not apply to the purchase of certain securities (such as government securities), there is no similar carve-out to the 10% concentration restriction on short-selling. This asymmetry in the Proposal may be problematic for alternative fund managers engaging in certain long/short strategies, such as those involved in short selling government securities.
The same short-selling restrictions applicable to alternative funds would also apply to closed-end funds.
Another important restriction related to short selling is that alternative funds would be only permitted to deposit up to 10% of their NAV with a borrowing agent, that is not its custodian or sub-custodian, as security in connection with a short sale. This is the same restriction that currently applies to conventional mutual funds. However, in order for an alternative fund to short sell 50% of its NAV, it could theoretically have to deal with five different borrowing agents which may not always be practical.
Combined limit on borrowing and short selling
The aggregate of all borrowing and exposure under physical short selling of an alternative fund is limited to 50% of NAV. Closed-end funds would also now be subject to this 50% limit under the Proposal.
Unlike conventional mutual funds, alternative funds would be permitted to use specified derivatives to create synthetic leverage (something closed-end funds are currently permitted to do). In addition, the Proposal codifies discretionary relief that has been granted in the past to allow for the collateral of “cleared specified derivatives” (those cleared through a clearing agency regulated under the laws of either a Canadian jurisdiction, the United States, or the European Union) to permit a fund to deposit assets with a dealer as margin in respect of cleared specified derivatives transactions.
Derivative counterparty requirements
Unlike conventional mutual funds and commodity pools, which are required to deal in derivatives or with counterparties that have a “designated rating”, alternative funds are exempt from these requirements, enabling them to engage in over-the-counter (OTC) derivatives transactions with a wider variety of counterparties. Closed-end funds are currently exempt from these requirements, and would continue to be exempt under the Proposal.
Exposure limit for derivative counterparties
In an apparent effort to counterbalance allowing alternative funds to enter into derivatives with possibly risky counterparties, the CSA has proposed to limit the exposure to any one counterparty (see below for more details). In essence, instead of ensuring that each counterparty meets a certain risk threshold, the CSA is mandating that alternative funds diversify the number of counterparties with which they deal. The analogy is that, instead of watching the basket of eggs very carefully, the CSA is mandating that alternative funds not put all of their eggs in one basket.
Alternative funds must limit their mark-to-market exposure with any one counterparty to 10% (subject to a general exception for certain cleared derivatives described above). This is a departure from current commodity pool rules, which do not restrict counterparty exposure.
Closed-end funds would also be subject to this 10% limit under the Proposal, which could make life difficult for funds with high levels of derivative exposure, as such funds may now have to use multiple clearing houses to meet the new requirements.
The total gross exposure achievable by an alternative fund through borrowing, short selling or the use of specified derivatives (including those used for hedging purposes) cannot exceed 300% of NAV. The total leverage limit would have to be satisfied on an ongoing daily basis. In this calculation, specified derivatives positions are valued at their aggregate notional amount. It is also important to note that exposure may also be obtained by investing in underlying funds that employ leverage.
The leverage limit of 300% of NAV is a departure from the current commodity pool rules, which have no limit on notional exposure. Closed-end funds would also now be subject to the leverage limit of 300% of NAV under the Proposal.
The CSA notes that there is no accepted industry standard for measuring leverage and that there are other possible ways in which it can be measured. It is seeking feedback on alternatives to the leverage measurement method chosen in the Proposal and on whether non-redeemable investment funds should be subject to the same total leverage limit. The CSA acknowledges that, in certain cases, notional amounts do not act as measures of potential risk exposure (e.g. interest rate swaps and credit default swaps) and are not representative metrics of the potential losses (e.g. short positions on futures). In particular, notional amounts may be problematic for valuing risk levels of exchange-traded options, where the notional amounts have virtually no relationship to the risk of the option. In contrast to the notional amount approach, the current industry practice seems to be to measure the risk of options using a “value-at-risk” metric.
Redemptions and NAV calculation
Under the current regime, mutual funds are required to calculate NAV weekly, unless they use specified derivatives or short sell, in which case they are required to calculate NAV daily. However, upon redemption, the redemption price must be the next NAV determined after receipt of the redemption order. If a mutual fund is required to calculate NAV daily (as would be the case for many alternative funds), this would create difficulties for funds redeemable on a weekly or monthly basis. The Proposals do adopt a carve-out from these current rules for alternative funds, which allows the redemption price to be the NAV determined on the first or second business day after receipt of the redemption order. However, while this may slightly lessen the problem for weekly or monthly redeemable alternative funds, it by no means solves it. In addition, purchases may pose a similar problem under the Proposal. The purchase price given to an investor must also be the next NAV determined after receiving the purchase order and there is no similar first or second business day carve-out to this requirement.
Provided that it is disclosed in the prospectus of the alternative fund, redemptions can be restricted for a period of up to six months after the receipt for the initial prospectus is issued.
Unlike conventional mutual funds, which can only charge performance fees tied to a reference benchmark or index, alternative funds may charge performance fees based on the total return of the fund itself. Performance fees are required to be subject to a high water mark.
Currently, many private hedge funds will reset their high water mark either on a regular basis (e.g. annually) or upon the occurrence of certain events (e.g. a recession with a specified number of quarters with negative returns). There is no apparent mechanism for a “reset” of the high water mark contemplated in the Proposal.
Proficiency and distribution
In contrast to the current rules for commodity pools, the Proposal does not impose additional proficiency requirements for dealing representatives that distribute alternative funds and that are members of the Investment Industry Regulatory Organization of Canada (“IIROC”) firms. For these IIROC dealers, proficiency is proposed to be addressed through the general requirement in section 3.4(1) of NI 31-103 Registration Requirements Exemptions and Ongoing Registrant Obligations (“NI 31-103”), which states that “[a]n individual must not perform an activity that requires registration unless the individual has the education, training and experience that a reasonable person would consider necessary to perform the activity contemplated.”
The CSA noted that it is in discussions with the Mutual Fund Dealers Association (“MFDA”) to determine the appropriate proficiency requirements for dealing representatives of mutual funds dealers to distribute securities of alternative funds. Accordingly, the Proposal may change in the future in order to incorporate proficiency requirements for MFDA dealing representatives.
Alternative managers that use exempt market dealers (“EMDs”) to distribute their products will not be able to distribute alternative funds under a simplified prospectus through EMDs, as EMDs cannot participate in offerings of prospectus-qualified securities.
Alternative funds can be distributed to retail investors under a simplified prospectus just as conventional mutual funds. Alternative funds not listed on a stock exchange would be subject to the same disclosure regime as conventional mutual funds under NI 81-101 Mutual Fund Prospectus Disclosure (“NI 81-101”), which includes the preparation of a simplified prospectus, annual information form and Fund Facts document. While under NI 81-101 multiple funds can be combined in a single simplified prospectus, the simplified prospectus for an alternative fund will not be permitted to be consolidated with the simplified prospectus for a conventional mutual fund.
Alternative funds will also have specific face page disclosure in the simplified prospectus and the Fund Facts equivalent document stating that the fund is an alternative fund under NI 81-102, how its strategies differ from conventional mutual funds, and what the specific investment risks are relative to conventional mutual funds.
In contrast to conventional mutual funds and alternative funds, closed-end funds and exchange-traded funds (“ETFs”) would still have to be offered through a long-form prospectus.
Additional requirements for Alternative Funds as public issuers
Alternative managers may offer both private pooled funds and public funds (i.e. conventional mutual funds or alternative funds) at the same time – there is no need to choose between the two. There are already a number of managers who, within their product offering, offer all of the following: conventional mutual funds, private funds offered through an offering memorandum, closed-end funds, ETFs etc.
Publicly offered alternative funds under a simplified prospectus would have to comply with the following additional requirements, among others: (i) establishing an IRC; (ii) filing annual and continuous disclosure; (iii) making quarterly portfolio reports, which must include certain information such as the fund’s top 25 holdings; and (iv) having a separate custodian, which under the current Proposal cannot also be the prime broker. For managers that decide to offer alternative funds under a simplified prospectus and continue to offer private pooled funds under an offering memorandum, it is important to note that the private pooled fund would not be subject to these public fund requirements.
Alternative funds would be subject to the custody requirements of NI 81-102, which provide that all the fund’s portfolio assets must be held by a custodian that qualifies as one of following:
a bank listed in Schedule I, II or III of the Bank Act (Canada);
a trust company that is incorporated under the laws of Canada or a jurisdiction and licensed or registered under the laws of Canada or a jurisdiction, and that has equity, as reported in its most recent audited financial statements, of not less than $10,000,000;
a company that is incorporated under the laws of Canada or of a jurisdiction, and that is an affiliate of a bank or trust company referred to in paragraph 1 or 2, if either of the following applies:
the bank or trust company has assumed responsibility for all of the custodial obligations of the company for that investment fund.
Currently, many private pooled funds hold their portfolio assets through their prime brokers who are IIROC dealers. These prime brokers may not currently satisfy the custodian requirements listed above. Therefore, alternative managers that wish to launch an alternative fund under a simplified prospectus will have to change to their custody arrangements in respect of the new alternative funds.
The custodian requirements are not new to closed-end funds which have been subject to these rules for a number of years. In order to address the custody issue one practice that has developed over the past few years is to use tri-party agreements between the custodian, the prime broker, and the fund, which allows the assets to remain with the prime broker, but gives the custodian rights to take custody of the assets in certain circumstances.
The CSA is currently finalizing amendments to implement a summary disclosure document similar to the Fund Facts documents that will be applicable to ETFs called ETF Facts. It is expected that the provisions of the ETF Facts will also be applicable to listed alternative funds and the complementary text box disclosure requirements discussed above will also be reflected in the ETF Facts form requirements once they come into effect.
Alternative funds would be subject to the same ongoing disclosure requirements as conventional mutual funds and other prospectus qualified investment funds, which includes annual audited and semi-annual unaudited financial statements, management reports of fund performance, annual information forms and timely disclosure of material changes.
Seed capital and organizational costs
Alternative funds would have minimum seed capital requirements of $150,000, the same as conventional mutual funds. Managers of alternative funds would be able to redeem this seed capital investment once the alternative fund has raised at least $500,000. This is a departure from the current commodity pool rules, which require the manager to maintain a minimum of $50,000 in seed capital for the life of the commodity pool.
Alternative funds will have the same prohibition against reimbursement of organizational costs as conventional mutual funds. In contrast, managers of closed-end funds and ETFs that are not in continuous distribution will continue to be able to pass on organizational costs to the funds.
If an alternative fund is distributed in Quebec, the fund will have an added cost of translating its offering documents into French.
Alternative funds would be subject to National Instrument 81-105 Mutual Fund Sales Practices (“NI 81-105”). Among other restrictions, sales commissions could not be charged to the alternative fund but must be paid by the manager.
Marketing of performance data
Alternative funds would be subject to the marketing practices in NI 81-102, including the restriction on linking the historical performance of the privately offered fund to that of the alternative fund in its sales communications. This is true even if the existing privately offered fund is “converted” into a publicly offered alternative fund until the fund has distributed its securities under a prospectus for at least twelve months.
The marketing rules of NI 81-102 do permit advertisements for a mutual fund that compare the performance of the mutual fund with other (i) mutual funds or asset allocation services that are under common management or administration or (ii) mutual funds or asset allocation services that have fundamental investment objectives that a reasonable person would consider similar.
In addition, it is notable that performance disclosure under NI 81-102 mandate specific disclosure of historical performance data. Standard performance data must be presented for the past one, three, five and ten years and also since inception of the fund.
Securityholder and regulatory approval of fundamental changes
The current rules that apply to all investment funds regarding fundamental changes (events requiring securityholder approval) would also apply to alternative funds. A change in the basis for calculating fees, fee increases, changes in the fundamental investment objectives of the fund or reorganizations would, among other things, require securityholder approval. In addition, the costs associated with any reorganization of the fund may not be borne by the fund itself.
Furthermore, regulatory approval would be required in the event of, among other things, a change in the manager of the alternative fund (other than to an affiliate) or a change of control of the manager.
If approved, the amendments regarding alternative funds would come into force approximately three months after the publication date of the final rule. For existing funds, the amendments would not apply for an additional six months after coming into force.
The fact that the Proposal would apply to existing funds may pose problems for some commodity pool funds or non-redeemable investments funds. For example, commodity pools may be using derivative strategies that create exposure above 300% of NAV and non-redeemable investment funds may be borrowing or short-selling above the 50% of NAV limit. Such funds would be forced to adjust their investment strategy, which may not be fair to either the fund’s investors or the fund itself. An alternative may be to allow grandfathering of the current investment restrictions for existing funds – in this case, any new funds would be subject to the new restrictions under the Proposal, but any existing funds would retain the benefit of the current restrictions.
Voluntary transition to an alternative fund
In contrast to a commodity pool fund, which becomes an alternative fund under the Proposal, an existing non-redeemable investment fund may choose to transition itself to an alternative fund once the new regime is established. However, there may be some practical challenges with such a transition, including the following: (i) a meeting of unitholders would have to be held in order to obtain unitholder approval, as the transition would likely constitute a change in investment objectives or restrictions; (ii) the constating documents of the fund would need to be amended; (iii) the custodial arrangements of the fund may have to change; and (iv) as discussed above, the fund may not be able to market its own historical performance prior to the transition. Existing conventional mutual funds can also choose to transition themselves into alternative funds, but they would experience similar challenges.
Conventional mutual funds would be able to invest up to 10% of their NAV in alternative funds and non-redeemable funds that are subject to NI 81-102 (which excludes privately offered funds). This may potentially significantly increase the demand for alternative funds, as conventional mutual funds in Canada hold approximately $1.3 trillion in assets.
Alternative funds would be able to invest up to 100% of their NAV in any other mutual funds (including alternative funds) or non-redeemable investment funds provided the other fund is subject to NI 81-102.
Under the Proposal, conventional mutual funds would be permitted to invest up to 100% of their NAV in any other mutual funds, other than alternative funds, that are subject to NI 81-102 (rather than just those that file a simplified prospectus under NI 81-101 as is currently the case for conventional mutual funds). The Proposal would also remove the restriction that a conventional mutual fund must only invest in another investment fund that is a reporting issuer in the same local jurisdiction as the top fund. Instead, a conventional mutual fund may invest in any investment fund as long as it is a reporting issuer in at least one Canadian jurisdiction. In addition, the Proposal maintains the restriction against conventional mutual funds investing in active ETFs (i.e. funds that are not index participation units) absent an exemption.
The Proposal does not modify the fund-on-fund provisions for non-redeemable investment funds. All investment funds would remain prohibited from investing non-prospectus-qualified funds.
Limits of the Proposal
Although the Proposal significantly increases the range of strategies that can be offered to retail investors, there remain certain strategies that would not be permitted under this new framework. For example, the proposed limit on short selling (50% of NAV) would not allow a typical 100% long/short market neutral strategy. In addition, the total leverage limit of three times NAV may restrict some managed futures strategies.
Comparison to the United States
For many years, mutual fund rules in the United States have been more flexible than those in Canada. For example, mutual funds in the United States have been able to employ leverage of up to 50% of NAV, a difference which has allowed them to implement alternative strategies not currently permitted for Canadian conventional mutual funds.
If the Proposal is approved, it could create significant opportunities for Canadian alternative managers. Managers that are able to adapt the strategies of their existing private pooled funds to fit within the Proposal will be able to offer their strategies to retail investors and allow alternative asset managers to market and grow their assets under management through a new distribution channel.