In the course of their ongoing review of publicly offered investment funds, the Canadian Securities Administrators (CSA) published on March 27, 2013 a Notice and Request for Comments on amendments to National Instrument 81-102 Mutual Funds (NI 81-102) and consequential amendments to National Instrument 41-101 General Prospectus Requirements (NI 41-101) and its Form 41 102F2 (the 81-102 Proposals). These amendments introduce core operational requirements for publicly offered non-redeemable “closed-end” investment funds (CEFs) (other than scholarship funds) and related disclosure changes. Comments on the 81-102 Proposals are due on or before June 25, 2013.
This review is part of the Fund Modernization Project, a mandate of the CSA to consider whether product and market developments in the Canadian investment fund industry are being adequately addressed by the current regulatory regime.
Phase 1 of the Fund Modernization Project is completed and addressed primarily publicly offered mutual funds by amending NI 81-102 and National Instrument 81-106 Investment Funds Continuous Disclosure (NI 81 106).
The CSA have now initiated Phase 2 of the Fund Modernization Project which attempts to harmonize regulatory regimes governing various forms of investment funds and addresses issues of market efficiency and uneven investor protection and fairness among these products.
This Notice and Request for Comments focusses on CEFs. It proposes core operational requirements similar to those applicable to publicly offered mutual funds including in particular investment restrictions, conflict of interest requirements and securityholder approval for fundamental changes.
The CSA’s proposal is based on the premise that the structural differences between conventional mutual funds and CEFs are not significant enough to justify from a policy standpoint the absence of investment restrictions for publicly offered CEFs.
In order that CEFs may continue to operate in a manner that offers a wide range of investment choices to investors, the CSA propose that CEFs either (i) comply with the new NI 81-102 requirements (this would accommodate funds with more passive investment strategies), or (ii) in order to accommodate CEFs with more complex or alternative investment strategies, comply instead with an expanded National Instrument 81-104 CommodityPools (NI 81-104) for “Alternative Funds”, as that term is introduced in the Notice. Draft amendments to NI 81-104 were not proposed in the Notice.
Nature of Changes Applying to CEFs
Pursuant to the 81-102 Proposals, the CSA have proposed making CEFs (other than Alternative Funds) subject to NI 81-102. For the most part, NI 81-102 would apply equally to mutual funds and CEFs, but the CSA recognize that the inherent differences between the two types of investment funds warrants distinct regulation in certain circumstances. Below we have described certain of the significant changes to CEFs that would result if the 81-102 Proposals were adopted.
- Investments in Physical Commodities - CEFs would be restricted in making direct or indirect investments in physical commodities to 10% of NAV at the time of purchase.
- Leverage and Fund of Fund Structures - The 81-102 Proposals would allow CEFs to borrow up to 30% of their NAV (greater than the 5% of NAV limitation to which mutual funds are subject). However, CEFs would only be permitted to borrow from certain Canadian financial institutions. As a result, CEFs would be prohibited from investing in other CEFs but could, however, invest in mutual funds subject to the same conditions currently prescribed for mutual funds.
- Conflicts of Interest - CEFs would be subject to the rules relating to conflicts of interest that currently apply to mutual funds, including restrictions on investing in securities of related issuers and restrictions on purchasing securities from related parties.
- Organizational Costs - Investment fund managers would be prohibited from passing on the organizational costs of a CEF to the fund itself. The CSA have proposed, however, that underwriting or agency fees in connection with a CEF’s initial public offering would not be considered organizational costs for this purpose.
- Securityholder and Regulatory Approvals - CEFs would be required to obtain securityholder approval in respect of certain material events, including an increase in fees and a change in fundamental investment objectives, similar to the current rules applicable to mutual funds. The 81-102 Proposals would also require securityholder approval in respect of a conversion from a mutual fund to a CEF or vice versa, as well as in respect of an investment fund changing to an issuer that is not an investment fund. Conventional flow-through limited partnerships and CEFs that are formed with the intention of converting to a mutual fund upon the occurrence of a specified event would be exempt from the requirement to obtain securityholder approval. In addition, the rules applicable to mutual funds in respect of securities regulatory authority approval for certain material events would extend to CEFs.
- Incentive Fees - Incentive fees of CEFs would be required to be based on the total cumulative return of the fund as compared to a specific benchmark or index.
- Issuance/Redemptions at NAV - The issuance and redemption of CEF securities could be effected at a price no greater than or less than NAV, respectively, in order to prevent dilution to securityholders. This requirement would mean that CEFs could no longer undertake rights or warrant offerings.
- Sales Communications - The 81-102 Proposals would make CEFs subject to the rules applicable to mutual funds in respect of sales communications, including requirements in respect of disclaimer, fee and performance history disclosure. CEFs would continue to be subject to the restrictions on sales communications during the prospectus waiting period set out in NI 41-101.
As discussed above, the CSA are considering amendments to NI 81-104 to include both mutual funds and CEFs that focus on asset classes or use investment strategies not permitted by the proposed amendments to NI 81-102. The CSA did not include proposed amendments to NI 81-104 in the Notice but rather only a summary of key elements of a proposed regulatory framework, regarding which they have sought feedback. Some of the key elements the CSA are considering are listed below.
- the replacement of the term “commodity pool” with “Alternative Fund”, which would include both mutual funds and CEFs;
- Alternative Funds would be permitted greater concentration limits than funds subject to NI 81-102, but the CSA are seeking feedback on what limit would be appropriate;
- whether Alternative Funds should be permitted to borrow cash up to a limit of 50% of NAV at the time of borrowing;
- whether Alternative Funds should be permitted to sell securities short beyond the limits in NI 81-102, including permitting short sales of securities of a single issuer to 10% of NAV at the time of the short sale and permitting the aggregate market value of all securities sold short by an Alternative Fund to be up to 40% of NAV at the time of purchase, as well as an exemption from the cost cover requirements of NI 81-102;
- restricting Alternative Funds from providing returns of more than two times the existing daily positive or inverse return of an underlying interest;
- whether the exemption in NI 81-104 from the requirement to comply with the counterparty exposure limits should be repealed for Alternative Funds;
- limiting total leverage for Alternative Funds (whether through borrowing, short selling, derivatives transactions and investing in underlying funds) at all times to 3:1, as well as considering other methods of measuring leverage;
- prohibiting the payment by an Alternative Fund of its organizational costs;
- whether further proficiency requirements should apply to dealing representatives who sell Alternative Fund securities; and
- the introduction of specific requirements relating to naming, prospectus disclosure, sales communications, continuous disclosure (including text box disclosure on the prospectus cover page and in sales communications), drawdown reporting and maximum and average daily leverage levels.
The comment period regarding the 81-102 Proposals and the proposed re-design of NI 81-104 will close June 25, 2013. The CSA anticipates finalizing certain aspects of the 81-102 Proposals in advance of others, including the proposed conflict of interest provisions, securityholder and regulatory approval requirements and custodianship requirements. The proposed investment restrictions are inter-related with the re-design of NI 81-104 and accordingly are expected to be considered in conjunction therewith.
The CSA is also asking for feedback on what a reasonable time frame would be to enable CEFs to transition to the new regime of NI 81-102 or the alternative regime of NI 81-104.
Action by Managers of Non-Redeemable Investment Funds
At this point, CEF managers may wish to assess how the published proposed changes to NI 81-102 will impact their funds’ structure and investment strategies and in particular:
- whether or not the fund’s investment strategies, such as those involving investing in physical commodities or specified derivatives on physical commodities, fund of fund structures with other CEFs or the use of leverage through specified derivatives, can be achieved in compliance with the proposed NI 81-102; if not, the manager will have to consider, when changes to NI 81-104 are published, if the fund’s investment strategies may fit into the proposed Alternative Fund regime;
- the fund manager will have to review its fund’s constating documents to determine what formalities (including notices to security holders, formalities for security holder approval, preparation of disclosure documents for meetings) have to be met for the fund’s structure to comply with the new requirements. In this regard, managers will need to take into account the new securityholder approval requirements mandated by amended NI 81-102 and NI 81-104, once they come into force, in addition to those of the fund’s constating documents.
A link to the CSA Notice and Request for Comments is provided below:
The proposed changes will have a significant impact on how CEFs are operated. The investment fund industry and investors in general are strongly invited to share their views on the issues the proposed changes to these products raise in the Canadian market.