The Canadian Securities Administrators (CSA) have published for comment two different proposals that affect securities lending arrangements, namely amendments to the early warning reporting (EWR) regime and amendments to the rules applicable to non-redeemable investments funds.
Early Warning Regime
The proposed amendments to the reporting threshold, triggers and related disclosure requirements under Canada’s early warning reporting (EWR) regime are intended to “provide greater transparency about significant holdings of issuers’ securities”. These amendments could affect the conduct of certain equity derivative transactions and related hedging activities.
Currently, under the EWR regime, prescribed disclosure is required by any investor that acquires beneficial ownership of, or the power to exercise control or direction over, 10% or more of any class of a public company’s voting or equity securities. Additional reporting is required on each incremental acquisition of 2%, as well as a change in a material fact contained in an earlier report.
The key changes under the proposals that affect securities lending arrangements include:
- decreasing the reporting threshold from 10% to 5%;
- clarifying that the reporting trigger applies to a 2% decrease in ownership and any decrease below the new 5% threshold;
- expanding the reporting trigger to capture descriptions of securities lending arrangements; and
- creating an exception for lenders under certain specified securities lending arrangements, but not for borrowers.
Reporting Threshold and Timing
The proposals provide for a decrease in the EWR threshold from the current 10% to 5%. Under the “moratorium” provisions of the EWR regime, which prohibit further purchases until one full business day after a report is filed, the cooling-off period would apply at the new 5% threshold.
Under the amendments, the required news release would have to be issued and filed promptly (as it is now), but no later than the opening of trading one business day following a reportable transaction. The timing for filing the report would not change.
According to the CSA, lowering the EWR threshold to 5% would recognize that investors are interested in the relevant information for more than simply a signal of a take-over bid. The change would thus address the increased prevalence of shareholder activism by recognizing the ability of 5% shareholders to influence control of an issuer, requisition a shareholders’ meeting or affect the outcome of significant transactions or the constitution of the issuer’s board of directors. The proposed new threshold would also harmonize Canada’s standard with that of several major foreign jurisdictions. In this regard, a 5% threshold would be consistent with jurisdictions including the United States, the United Kingdom and Australia.
With respect to securities lending arrangements, the CSA are concerned with “empty voting” strategies whereby borrowers hold voting rights in respect of an issuer and possibly influence the outcome of a shareholder vote without having an equivalent economic stake in the issuer given that all economic interest is passed back to the lender (they have similar concerns with certain equity derivatives). In the CSA’s view, market transparency and integrity would be enhanced by such disclosure.
Treatment of Securities Lending Arrangements under EWR
According to the CSA, the current regime requires the lender and borrower to consider the securities disposed of and acquired, respectively, in determining whether the reporting requirement has been triggered, notwithstanding the duration of the loan.
In light of the proposed requirement to report 2% decreases in ownership, the reporting requirement would specifically apply to lenders under securities lending arrangements.
However, the proposals would exempt the lender from reporting securities lent out as a disposition or reacquired on termination of the loan under a “specified securities lending arrangement” that provides an “unrestricted” ability for the lender to recall the securities (or identical securities) before the record date for a meeting of securityholders and/or requires the borrower to vote the securities in accordance with the lender’s instructions. Other requirements to qualify as a specified securities lending arrangement would include that there must be a written securities lending agreement, the arrangement must provide for payment of equivalent income payments as if the securities had not been lent and the lender must have policies and procedures on maintaining records of its securities loans. The borrower is not exempt under a specified securities lending arrangement because of the empty voting concern.
Also, if the lender is reporting a transaction that is not a specified securities lending arrangement, it will have to disclose what specified securities lending arrangements are in place at that time, even if such transaction was not related to the securities lending arrangement.
Enhanced Early Warning Report Disclosure
Current disclosure requirements exclude having to disclose the general nature and material terms of lending arrangements. This will change under the proposal. Lenders and borrowers will have to disclose the material terms of any reportable securities lending arrangement (including duration and recall provisions) and the same with respect to any specified securities lending arrangement where it is being reported in the context of another reportable transaction.
Implications of the Proposed Changes
- The proposed changes may result in increased compliance costs and we would expect the volume of reporting under the EWR regime to increase significantly.
- With the lower 5% threshold, securities lenders and borrowers who may not have previously been caught may have to publicly disclose holdings.
- Securities lenders will need to distinguish between specified securities lending arrangements and those that are not and implement different reporting processes for each.
The CSA’s request for comments, which specifically poses a number of questions regarding the thresholds and proposals, is open until June 12, 2013.
Securities Lending and Investment Funds
The CSA is also proposing amendments to National Instrument 81-102 Mutual Funds (NI 81-102) that would bring non-redeemable investment funds within the scope of the instrument that applies to reporting issuers. This is Stage 1 of Phase 2 of the CSA’s plan to modernize the regulation of investment funds. The purpose of the amendments is to create consistency in product regulation between various types of publicly traded funds. Some of the proposed changes, however, impact securities lending arrangements.
Pursuant to the amendments, NI 81-102 would apply to both mutual funds and non-redeemable investment funds, with the latter being essentially subject to the same core requirements as the former. The CSA is also proposing, for Phase 3, the creation of an “alternative investment fund” classification under which mutual funds and non-redeemable investment funds could be designated. Under this classification, less restricted product and strategy requirements would apply (as under what is now the commodity pool regime in National Instrument 81-104 – Commodity Pools).
Currently, mutual funds cannot borrow securities, but can lend securities subject to the requirements set out in NI 81-102 (s.2.12), which include obtaining at least 102% collateral value, requiring that loans terminate on demand, requiring the borrower to make all equivalent income payments, meeting the requirements of the Income Tax Act for the securities lending arrangement safe-harbour, and ensuring that the market value of all securities loaned is no more than 50% of the “total assets” of the fund, not including collateral received for securities loans and repo sales. What is acceptable collateral is also prescribed. In addition, mutual funds must use a securities lending agent who is the custodian of the fund. Prospectus disclosure is required with regards to the intention to engage in securities lending.
Under the CSA’s proposal, these securities lending requirements would also be extended so as to apply to nonredeemable investment funds. The 50% total asset test would be changed to a 50% net asset value test for both types of funds.
There is also a request for feedback on disclosure relating to the costs of securities lending (see Annex C of the proposal). The CSA believe greater transparency is required with respect to the costs, particularly if the agent is related to the manager. It may be misleading if the fund is marketed as having a lower management fee, but the affiliated agent is collecting fees under the securities lending agency agreement. Current financial statement disclosure allows disclosure of return from securities lending on a net basis. The CSA is requesting feedback on what would be the most appropriate type of disclosure.
Agency Relationship Disclosure
The CSA are also considering requiring information about the agent to be disclosed in the AIF or prospectus, including whether the agent has an indemnity obligation under the arrangements and whether SEDAR disclosure of the securities lending agency agreement should be required.