On October 4, 2018, the Canadian Securities Administrators (the CSA) published amendments (the Amendments) to National Instrument 81-102 Investments Funds (NI 81-102) and National Instrument 81-104 Commodity Pools (NI 81-104) to establish the new “alternative mutual funds” regime. Subject to Ministerial approval, the Amendments will come into force on January 3, 2019.
Canadian public investment funds, including conventional mutual funds, exchange-traded funds (ETFs) and non-redeemable funds (i.e., closed-ended funds) are subject to investment restrictions and limitations under NI 81-102. Historically, exceptions to these restrictions were provided for commodity pools, which were specialized mutual funds permitted to invest in derivatives and physical commodities under former NI 81-104 in a manner not permitted for other Canadian public investment funds. The alternative mutual funds regime modernizes the commodity pool regime by expanding the scope of alternative strategies in which such funds may invest, including various leverage strategies described in the chart below. Existing commodity pools will automatically become alternative mutual funds when the Amendments come into force but will have until July 4, 2019 to comply with the new rules applicable to alternative mutual funds.
Since May 2018, the CSA has approved a few families of alternative mutual funds which launched ahead of the publication of the Amendments pursuant to discretionary exemptive relief.
The Amendments are part of the final phase of the CSA’s investment fund modernization project, published in draft in September 2016 and described in our Update “CSA proposes a regulatory framework for offering hedge funds to the public.”
Investment restrictions and limitations
The chart below summarizes the primary differences between investment restrictions and limitations under NI 81-102 that will be applicable to conventional mutual funds and ETFs, alternative mutual funds and non-redeemable investment funds when the Amendments come into force.
Proficiency standards for mutual fund dealing representatives
Like their predecessor commodity pools, alternative mutual funds may only be sold by mutual fund dealing representatives who meet enhanced proficiency requirements, including a passing grade in the Canadian Securities Course or Derivatives Fundamentals Course, or completion of the Chartered Financial Analyst program. The CSA had indicated in the draft Amendments that new proficiency requirements might apply under the alternative funds regime, however, these changes have been deferred and will be addressed in the CSA’s ongoing work on more holistic changes to dealer proficiency standards. Once this work is complete, the CSA expects to repeal NI 81-104, as the only provisions left in the old commodity pools rule are the proficiency requirements.
Alternative mutual funds are permitted to charge incentive fees based on the performance of the fund, provided that the fee is based on the cumulative total return of the fund for the relevant performance period and the calculation methodology for the fee is disclosed in the prospectus of the fund. No other public investment funds are permitted to charge performance-based compensation. The ability to charge incentive fees reflects the typical compensation structure of private alternative funds (commonly known as “hedge funds”) and is consistent with the former commodity pool regime.
In its consultation on the draft Amendments, the CSA solicited comment on whether the investment risk classification methodology, which applies to other public investment funds and is based on the fund’s standard deviation from a reference index, would be appropriate for alternative mutual funds. Although numerous suggestions for alternative risk rating frameworks were proposed by alternative investment managers, the CSA decided to maintain a uniform methodology for all public mutual funds in order to foster greater comparability of risk ratings. The Amendments provide additional guidance for funds to consider when they employ an investment strategy which result in atypical distribution of performance results, encouraging such funds to use “upside discretion” for their risk ratings.
Changes to the custodian regime
Part 6 of NI 81-102 contains a rigorous custodial regime for Canadian public investment funds. As part of implementation of the alternative mutual funds regime, NI 81-102 will be expanded to permit: (a) margin to be posted for transactions inside and outside of Canada involving cleared specified derivatives with eligible dealers and clearing corporation members provided the amount of margin with any one dealer or clearing corporation member does not exceed 10% of the fund’s NAV; (b) fund assets over which a security has been granted may be deposited with an eligible lender of cash to the fund; and (c) for alternative mutual funds and non-redeemable investment funds, to permit the deposit of fund assets with non-custodian borrowing agents (in connection with short sales) provided such assets do not exceed 25% of the fund’s NAV at the time of deposit. The existing custodial exceptions for margin in respect of clearing corporation options, options on futures and standardized futures, assets deposited with OTC derivatives counterparties, and assets delivered in connection with securities lending, repurchase transactions and reverse repurchase transactions largely remain unchanged.
The Amendments also remove the requirement for certain sub-custodians to have their audited financial statements made public to be qualified to act as a custodian or sub-custodian, primarily to allow bank-owned dealers with consolidated financial statements to provide services to alternative mutual funds.