As we discussed in an earlier post, the Canadian Securities Administrators recently released proposed changes to National Instrument 81-102 Mutual Funds that would introduce core operational requirements for publicly offered non-redeemable investment funds (commonly referred to as “closed-end funds”) as part of its investment fund modernization project (this part specifically referred to as “Phase 2”). Included as part of Phase 2 is the creation of a comprehensive alternative fund framework (the “Alternative Fund Framework”) through amendments to National Instrument 81-104 Commodity Pools, which would apply to mutual funds and non-redeemable investment funds that use certain “alternative” investment strategies that would not be permitted under NI 81-102.
If Phase 2 is implemented in the form proposed, the regulation of non-redeemable investment funds will see significant changes in that such funds would be subject to operational requirements that are generally analogous to those currently applicable to mutual funds. According to the CSA, Phase 2 would provide baseline protections for investors, mitigate the potential for regulatory arbitrage and contribute to more efficient capital markets.
Some of the key elements of Phase 2 are discussed in further detail below.
Mutual Funds vs Non-Redeemable Investment Funds
The CSA acknowledge that while mutual funds and non-redeemable investment funds are similar in many ways, there are certain key ways in which the two types of funds differ. The differences acknowledged by the CSA include the frequency of redemptions and the channel through which their securities are distributed.
Phase 2 would extend the application of many of the investment restrictions under NI 81-102 that currently apply only to mutual funds to non-redeemable investment funds. The CSA’s view is that these investment restrictions represent fundamental requirements that impose constraints designed to limit risks for retail investors and accordingly should apply to both mutual funds and non-redeemable investment funds. These investment restrictions, on the whole, are meant to a) establish parameters for funds to meet retail investors’ expectations when investing in pooled investment products, b) prohibit certain activities that are inconsistent with the fundamental characteristics of funds as passive investment vehicles, and c) ensure that managers adhere to prudent fund management practices.
The CSA note that many such restrictions have been adopted by existing non-redeemable investment funds and are often imposed by the investment dealer syndicate. Some of the more noteworthy investment restrictions that are proposed to apply to all investment funds upon the implementation of Phase 2 are:
- imposing a 10% a concentration restriction (except for fixed portfolio exchange-traded funds (ETFs));
- limiting investments in physical commodities and specified derivatives with underlying interests in physical commodities;
- limiting borrowing activities to cash borrowing of up to 30 % of NAV (and permitting borrowing only from “Canadian financial institutions”);
- limiting investments in mortgages to guaranteed mortgages only;
- prohibiting non-redeemable investment funds from investing in other non-redeemable investment funds (fund-of-funds);
- imposing a restriction on investment in illiquid assets (threshold to be determined); and
- imposing a framework for securities lending, repurchases and reverse repurchases similar to that applicable to mutual funds.
Phase 2 would introduce new requirements for the manager to bear the organizational costs of launching a new fund. Currently, the organizational costs are paid out of the proceeds of the initial public offering of the non-redeemable fund and are borne by investors, while managers of mutual funds pay the organizational costs of establishing new mutual funds and recoup such costs through ongoing management fees. The CSA acknowledge the fact that non-redeemable investment funds are not offered on a continuous basis, which has historically accounted for the difference in how organizational costs are paid. The CSA believe that the benefits to such a change include a) aligning the interest of managers with those of investors, b) increasing managers’ efficiency when launching funds and c) leveling the playing field between managers of mutual funds and non-redeemable investment funds. The CSA also note that they have “observed several instances” of managers launching non-redeemable investment funds that convert to mutual funds within a short period of time after launch thereby resulting in the launch of mutual funds without the manager paying any organizational costs.
Restrictions on Dilutive Offering and Warrants
Phase 2 proposes to introduce a requirement that issuances of non-redeemable investment fund securities not cause dilution to existing securityholders, paralleling the requirements that mutual fund securities be issued at NAV. In addition, there would be specific prohibitions on the ability to issue warrants or similar convertible securities. The CSA express concerns that warrant offerings are coercive and that securityholders may feel obligated to make additional investments or face the risk of dilution and that investors in non-redeemable investment funds may not expect the costs of warrant issuances to be part of their investment bargain. Further, the CSA are doubtful that investors who do not exercise warrants are able to effectively mitigate potential dilution by selling their warrants (or similar convertible securities) in the market.
Phase 2 proposes to provide investors in non-redeemable investment funds with similar protections and rights as mutual fund investors relating to certain fundamental changes to their fund. To achieve this, the list of matters requiring the prior approval of securityholders in Part 5 will also apply to non-redeemable investment funds. While the constating documents of many non-redeemable investment funds include certain investor voting rights, the CSA are looking to codify such rights, as, in their view, such rights are inconsistent from fund to fund.
Phase 2 also proposes to require the prior approval of securityholders to implement certain transactions that would change the nature of the investment fund (e.g., converting a non-redeemable investment fund to or from a mutual fund or converting an investment fund to an issuer that is not an investment fund). Further, the costs of any such changes would not be borne by the fund. Certain investment funds with an automatic conversion feature may be able to rely on limited exemptions, and an exemption specific to flow-through limited partnerships would also be available in connection with a mutual fund rollover transaction, in each case, provided certain criteria are met (including prospectus disclosure requirements).
Additionally, a change of control in the manager of a non-redeemable investment fund will require the prior approval of the applicable securities regulatory authority under the revised NI 81-102.
Phase 2 proposes to apply Part 7 of NI 81-102 to the payment of incentive fees by non-redeemable investment funds. Part 7 requires incentive fees to be calculated with reference to a “relevant benchmark”, being one that a) reflects the sectors in which the fund invests, b) is available to persons other than the fund and its service providers and c) is a total return benchmark or index. The commentary provided by the CSA suggest that the Alternative Fund Framework will provide for alternate rules concerning incentive fees that will allow for the payment of incentive fees for funds that fall under the Alternative Fund Framework.
Other Items of Note
Amendments under Phase 2 also prescribe new requirements governing conflicts of interest and propose changes to requirements for custodianship of assets, redemptions and additional prospectus disclosure.
Priority Items for Comment – New August 23, 2013 Deadline
On June 25, 2013, after receiving feedback from stakeholders indicating that Phase 2 represents fundamental changes to the regulation of non-redeemable investment funds, the CSA announced an extension to the comment period regarding Phase 2 to August 23, 2013 (see CSA Staff Notice 11-324). In particular, the CSA invite stakeholder comments on certain prioritized amendments to NI 81-102, including:
- the application of the investment restrictions under Part 2 of NI 81-102 to non-redeemable investment funds, other than those relating to (i) investments in physical commodities, (ii) borrowing cash, (iii) short selling, and (iv) the use of derivatives, all of which are interrelated with the proposed Alternative Fund Framework and will require more time to consider and evaluate in conjunction with any related amendments to NI 81-104;
- having the manager bear the organizational costs for new non-redeemable investment funds (section 3.3 of NI 81-102);
- conflicts of interest provisions (Part 4 of NI 81-102);
- securityholder and regulatory approval requirements for fundamental changes to non-redeemable investment funds and their management (Part 5 of NI 81-102);
- custodianship requirements (Part 6 of NI 81-102);
- sales and redemptions of securities of non-redeemable investment funds, including the proposed prohibition on warrant offerings by investment funds (Parts 9 and 10 and proposed Part 9.1 of NI 81-102);
- commingling of cash relating to sales and redemptions of non-redeemable investment fund securities (Part 11 of NI 81-102);
- record date requirements (Part 14 of NI 81-102);
- sales communications parameters (Part 15 of NI 81-102); and
- securityholder record requirements (Part 18 of NI 81-102).
Alternative Fund Framework
As proposed, the Alternative Fund Framework would consist of an overhaul of NI 81-104 (which currently applies only to specialized mutual funds that are commodity pools) to apply to both mutual funds and non-redeemable investment funds. The stated intention behind the Alternative Fund Framework is to preserve the flexibility for non-redeemable investment funds to use “alternative” investment strategies that would otherwise be prohibited once the amendments to NI 81-102 are implemented. In connection with allowing investment funds to use “alternative” investment strategies, the CSA are considering whether additional proficiency requirements (i.e. taking additional courses or having additional experience) should apply to individual dealing representatives who sell securities of investment funds under the Alternative Fund Framework.
While the CSA have indicated that the proposed Alternative Fund Framework is being considered as a part of Phase 2, their current focus is on the amendments to NI 81-102. At this time, the CSA have not proposed specific amendments to NI 81-104. Without a draft of the proposed amendments to NI 81-104, the implications for a non-redeemable investment fund that desires to fit into the Alternative Fund Framework remain unclear. The CSA, through the release of the prioritized amendments to NI 81-102, have arguably acknowledged that certain changes to NI 81-102 should be considered in conjunction with the Alternative Fund Framework.