John Black, Andrew W. Aziz
July 20, 2010
On June 25, 2010, the Canadian Securities Administrators (CSA) published for comment proposed changes to National Instrument 81-102 – Mutual Funds (NI 81-102) and National Instrument 81-106 – Investment Fund Continuous Disclosure (NI 81-106), along with consequential amendments to certain other instruments governing investment funds. The proposed amendments represent the first of two phases of the CSA’s larger project of modernizing the regulation of conventional mutual funds and other investment funds. In phase one of this project, the CSA proposes to codify exemptive relief that has frequently been granted to mutual funds from certain requirements of NI 81-102, create additional operational requirements for money market funds, update various provisions and remove provisions that are no longer relevant.
In general, we do not anticipate that most of these changes will be controversial or unduly burdensome to industry participants. However, the operational requirements for money market funds should be carefully considered as they may require substantive changes to current money market fund portfolios, and the CSA is specifically requesting comments on certain of the requirements.
The CSA has indicated that it will consider in the second phase of the project whether the differing regulatory regimes that apply to different types of investment funds and other competing retail investment products create any market efficiency, fairness or investor protection issues and, if so, whether NI 81-102 should be amended to deal with these issues.
Summary of the Proposed Amendments
Exchange-Traded Mutual Funds
When NI 81-102 was introduced, it did not contemplate the various structures used by exchange-traded mutual funds (ETFs). As such, the CSA is proposing to update NI 81-102 as follows to codify some of the relief that has frequently been granted to ETFs:
- Amend Part 14 of NI 81-102 to enable ETFs to establish record dates for receiving dividends or distributions in accordance with the rules of the exchange on which the ETF is listed.
- For ETFs that are in continuous distribution:
- amend subsections 9.4(2) and 10.4(3) of NI 81-102 to permit them to receive a combination of cash and securities as payment for the purchase of mutual fund securities and to pay redemption proceeds with a combination of cash and securities; and
- amend section 10.3 of NI 81-102 to permit them to pay a redemption price that is based on the closing price of the ETFs’ securities on the stock exchange in the case of redemptions of less than a certain size.
- For ETFs that are not in continuous distribution, including fixed portfolio ETFs (i.e., ETFs not in continuous distribution whose investment objectives include holding and maintaining a specified fixed portfolio of publicly-listed equity securities):
- amend section 2.6 of NI 81-102 to allow them to borrow cash or provide a security interest over portfolio assets to finance the acquisition of portfolio securities, which borrowing must be repaid on completion of the ETFs’ initial public offerings;
- amend section 3.3 of NI 81-102 to create an exemption from the prohibition against the reimbursement of organizational costs;
- amend section 10.3 of NI 81-102 to allow them to redeem securities at a price that is less than the net asset value of the security determined on a date specified in the prospectus or, if applicable, the annual information form; and
- amend section 10.4 of NI 81-102 to allow them to pay the proceeds of a redemption order more than three days after the valuation date on which the redemption price was established.
- For fixed portfolio ETFs, amend section 2.1 of NI 81-102 to create an exemption from the concentration restriction for purchases of equity securities in accordance with their investment objectives.
Investments in Other Mutual Funds
The CSA is proposing the following amendments to broaden the ability of mutual funds to invest in other mutual funds:
- amend the definition of “index participation unit” to include securities traded on a stock exchange in the United Kingdom in addition to those traded on a stock exchange in Canada or the United States;
- amend subsection 2.5(2) of NI 81-102 (and make related changes to provisions relating to the concentration and control restrictions for funds-of-funds) to allow mutual funds to purchase and hold securities of another mutual fund provided that the other mutual fund is subject to NI 81-102, offers or has offered (but is no longer distributing) securities under a simplified prospectus in accordance with National Instrument 81-101 – Mutual Fund Prospectus Disclosure and is a reporting issuer in the jurisdiction; however, the amendments would require that both the top fund and underlying funds be reporting issuers in a local jurisdiction;
- amend the now-obsolete exemption in paragraph 2.5(4)(a) of NI 81-102 for RSP clone funds so that the exemption would apply to investments in a “clone fund”, which would be defined as a mutual fund that has adopted a fundamental investment objective to link its performance to the performance of another mutual fund; and
- amend subsection 2.5(5) of NI 81-102 such that the prohibition in paragraph 2.5(2)(e) of NI 81-102 against a mutual fund paying sales and redemption fees in connection with the purchase or sale of securities of a related mutual fund does not apply to prohibit the mutual fund from paying brokerage commissions on the purchase or sale of index participation units issued by a related mutual fund.
The CSA is proposing to amend NI 81-102 to codify the exemptive relief that they have frequently granted to permit mutual funds to engage in short selling subject to compliance with certain conditions, including maintaining an overall 20% cap on short selling and a further 5% cap on exposure to any one issuer, holding cash cover of at least 150% of the market value of securities sold short, borrowing securities intended to be sold short through a qualified “borrowing agent” and not using the proceeds of short sales to enter into long positions in securities other than cash cover. Mutual funds would also need to provide notice that they are commencing short selling in the same manner that is required for the commencement of the use of specified derivatives and disclose short selling as an investment strategy in their disclosure documents.
The CSA has proposed certain amendments to the definition of “cash cover” in NI 81-102 to provide mutual funds with more flexibility to select securities to use as cash cover. The new definition would include (i) evidences of indebtedness with a remaining term to maturity of 365 days or less and an approved credit rating; (ii) certain floating rate evidences of indebtedness whose interest rates reset no less frequently than every 185 days and the principal amounts of which continue to have a market value of approximately par on each rate reset; and (iii) securities of money market funds. In addition, section 2.7(1) of NI 81-102 would be amended to remove the term limit on specified derivatives.
Money Market Funds
The CSA is proposing amendments relating to the restrictions on money market funds, including:
- allowing money market funds to hold securities issued by other money market funds, so long as the investment complies with section 2.5 of NI 81-102;
- restricting money market funds from using specified derivatives or selling securities short;
- creating new liquidity provisions requiring money market funds to have at least 5% of their assets in cash or readily convertible to cash within one day and 15% of their assets in cash or readily convertible to cash within one week; and
- introducing a revised dollar-weighted average term to maturity limit: the CSA propose to maintain the current requirement of maintaining a dollar-weighted average term to maturity limit not exceeding 90 days calculated on the basis that the term of a floating rate note is the period to the next rate-setting of the note, but to combine this requirement with a new dollar-weighted average term to maturity limit of 120 days that is calculated based on the actual term to maturity of all securities in a money market fund portfolio, including floating rate notes.
Mutual Fund Dealers and Commingling Restrictions
The CSA also proposes exempting principal distributors and participating dealers that are members of the Mutual Fund Dealers Association of Canada (MFDA), as well as mutual fund dealers in Quebec, from (i) restrictions against holding in the same trust account, cash for or from an investment in a mutual fund with cash for or from other products the dealers sells; (ii) the requirement to account separately for cash received in connection with a mutual fund purchase or redemption transaction and to deposit the cash in an interest-bearing account until disbursed, and to pay out the interest earned on that cash either to the client or the mutual funds to which the account pertains; and (iii) the requirement to file reports describing compliance with Parts 9-11 of NI 81-102. Mutual fund dealers would remain subject to the applicable rules of their self-regulatory organization (such as the MFDA).
The CSA has also proposed amendments relating to:
- how mutual funds may use performance ratings or rankings in sales communications;
- the updating of language to reflect changes in Canadian tax law and the evolution of certain self-regulatory organizations;
- the repeal of subsection 3.5(4) and (5) of NI 81-106 so that investment funds may no longer rely on these provisions to aggregate certain types of short-term debt in their statements of investment portfolio;
- the amendment of NI 81-106 to create a limited exemption from the requirement to file an annual information form for “limited life funds,” which are defined as investment funds established to fulfil a specific short-term objective, whose securities are not redeemable and not listed on an exchange or quoted on an over-the-counter market and whose prospectuses discloses that the manager intends to cause them to be terminated within 24 months of their formation;
- a new requirement for investment funds to make their net asset value available to the public at no cost; and
- a new requirement for investment funds that engage in short selling to calculate their net asset value daily.
The CSA has also proposed consequential amendments to the investment fund prospectus rules which are intended to support the changes outlined above.
The CSA has requested that comments on the above proposals be submitted by Friday, September 24, 2010.
Should you have any questions about the proposed changes, please do not hesitate to contact the authors.