IIROC Proposed Amendments to Client ID and Verification Requirements: The Argument for Red Tape Reduction

Darin Renton -

On July 6, 2017, IIROC published for comment IIROC Notice 17-0139 Proposed Amendments to Client Identification and Verification Requirements. IIROC is proposing changes to Part A of Rule 3200 of the proposed IIROC Dealer Member Plain Language Rule Book (the Proposed Amendments). The Proposed Amendments are designed to make IIROC rules consistent with National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) and the Proceeds of Crime (Money Laundering) and Terrorist Act and its accompanying regulations, including the Proceeds of Crime (Money Laundering) and Terrorist Financing Regulations (defined in the Notice as the “AML Requirements”).

Effects of the Proposed Amendments

The Proposed Amendments would:

  • Update the information Dealer Members are required to collect on clients who are not natural persons (such as corporations, partnerships and trusts)
  • Change the amount of time Dealer Members have to confirm certain client information
  • Reduce the number of clients who are exempt from Part A of Rule 3200 of the proposed IIROC Dealer Member Plain Language Rule Book (the IIROC Rules)

Part 3 of the Notice outlines the impact of the Proposed Amendments described as "generally more lenient on Dealer Members". Certain additional requirements are being imposed on Dealer Members to align IIROC Rules with NI 31-103 and AML Requirements. IIROC does not anticipate these amendments having a significant impact on Dealer Members as they are already required to comply with these requirements under the AML Rules.

To better align with NI 31-103, IIROC also proposes that Dealer Members must take reasonable steps to keep client identification information current. Like NI 31-103, the Proposed Amendments do not specify when such records must be updated. Under 31-103CP, the CSA consider information to be current if it is sufficiently up-to-date to support a suitability determination. The CSA had proposed a default requirement to perform a suitability assessment at least once every 12 months, which would impact the requirement to keep client identification information current, but is now reconsidering this position.

Red Tape Reduction

The chart under Section 2.6 of the Notice (page 6) is very interesting. By comparing the Proposed Amendments to the IIROC Rules, AML Rules and NI 31-103, it highlights numerous minor but otherwise inexplicable inconsistencies in the rules. The number of inconsistencies and the fact that IIROC has to rule-make to reconcile them are arguments for red tape reduction. Although they are minor, such inconsistencies matter because they permeate things like on-boarding procedures, KYC and AML forms and subscription agreements. Duplicative and inconsistent regulation can be confusing and costly for registrants and their advisers to navigate and make sense of.

Next Steps

IIROC plans to implement the Proposed Amendments when the proposed PLR Rule Book becomes effective(which will happen only after a training and implementation period that may extend well into 2018). Comments on the Proposed Amendments should be made in writing and delivered by August 8, 2017.

Arguably, regulations and requirements affecting registrants should be included in the initiatives to reduce regulatory burden currently being undertaken by the CSA, as set out in its 2016-19 business plan, and the OSC, as set out in its 2017-18 Statement of Priorities.

CSA Sweep Uncovers Small Firm Business Continuity Plan Deficiencies

Darin Renton -

The Canadian Securities Administrators (CSA) recently released the results of a compliance review focused on sole proprietorships and other firms with just one registered individual.  CSA Staff Notice 31-350 – Guidance on Small Firms Compliance and Regulatory Obligations is the product of a two-year “sweep” that concluded in mid-2016. The sweep examined the policies and practices of 65 small firms, including investment fund managers, portfolio managers and exempt market dealers.

Readers can also refer to our August 2016 post on Staff Notice 33-747Annual Summary Report for Dealers, Advisers and Investment Fund Managers, in which the OSC noted that this analysis was underway.

Common Deficiencies

The CSA sweep uncovered widespread deficiencies, including inadequate or missing business continuity plans (BCPs) (35% of firms), inadequate monitoring systems (71% with inadequate written policies), unfulfilled regulatory filing obligations (34%), non-compliant client statements (45%) and inadequate relationship disclosure materials (63%).

CSA’s Business Continuity and Succession Tips

While the sweep addressed a number of issues, we will spotlight two – business continuity and succession planning – that are significant concerns for many small firms.

The CSA is recommending that, in managing risks related to business interruption, small firms should consider:

•   Developing a BCP that is appropriate for their size and business model;

•   Designating an individual to execute the BCP (BCP executor); and

•   Reviewing the BCP annually.

A BCP executor may be external to the firm, such as a spouse, relative, legal counsel or another registrant. The CSA outlines best practices to ensure that an external BCP executor understands his or her role. Exemptive relief may be granted on an expedited basis to assist in implementing a BCP if the BCP executor would otherwise be restricted from acting for more than one registered firm.

With respect to succession planning, the CSA is advising small firms that their BCPs should describe the succession or winding-up procedures that will be followed in the event that their registered individual dies, is incapacitated or is otherwise absent from the business for an extended period. Such procedures would include (among others) deciding who is responsible for notifying regulators in such circumstances and determining how clients of the firm are to be told of such an event and how they will then be able to access their assets.

Additional Issues

The CSA provides guidance and best practice tips on other issues addressed in the report, which those responsible for compliance at small firms may find useful. Those issues include monitoring systems, annual CCO reporting requirements (even in a sole proprietorship), interim financial statements, and accounting principles and inadequacies in the working capital reporting under Form 31-103F1 – Calculation of Excess Working Capital.  Documentation and record-keeping to evidence compliance are key. For example, the CCO of a small firm can meet the annual report requirement by documenting his or her assessment in the firm's board of directors' minutes.

The CSA noted, in concluding, that it intends to continue to monitor small firm compliance issues.

OSC investor panel supports "Best Interest" standard and ban on conflicted advice by Investment Advisors

Encouraging the adoption of a best interest standard for investment advisors continues to be a key goal of the Investor Advisory Panel (IAP) of the Ontario Securities Commission, according to the IAP’s newly released 2016 Annual Report. Other top priorities of the seven-member panel include:

  • Conflicts of interest and conflicted compensation;
     
  • Accuracy in risk profiling;
     
  • Strengthening the Ombudsman for Banking Services and Investments; and
     
  • The future of the IAP within the new Capital Markets Regulatory Authority.

Eliminating Conflicts

The Report underscores the IAP’s view that conflicts of interest and conflicted compensation are unacceptable and that proposals in CSA Consultation Paper 33-404 requiring merely that such conflicts be disclosed are insufficient from a retail investor perspective. In 2017, the IAP intends to prepare a response to the CSA paper arguing that embedded commissions and conflicted compensation must be banned outright.

Adopting a Best Interest Standard

Adoption of a best interest standard would be one key step toward the elimination of conflicts. Among other things, this would involve the industry-wide implementation of remuneration structures that aligned advisor and investor interests. In 2016, the IAP urged both IIROC and the MFDA to support a best interest standard and in 2017 it intends to support ongoing OSC efforts in this area (see the OSC’s 2017-18 Statement of Priorities).

Improving Risk Profiling

The IAP has continued to express concern about the shortcomings of current know-your-client risk profiling. A study conducted on the IAP’s behalf in 2015 concluded that 83% of examined risk profile questionnaires were unfit for the purpose. In 2016, the IAP followed up on these findings with a Risk Profiling Roundtable involving investors, industry and regulators.

Strengthening the Ombudsman’s Office

Another concern of the IAP is what it describes as “industry’s refusal to accept” findings and recommendations of the Ombudsman for Banking Services and Investments (OBSI). The IAP argues that OBSI should work on an arbitration model rather than a mediation model, with the ability to make binding decisions. Pursing this goal is a top IAP priority for 2017.

Adapting to the Common Regulator

The IAP is concerned that those developing the new multi-jurisdictional Capital Markets Regulatory Authority (CMRA) have not paid enough attention to the need to incorporate mechanisms for the airing of investor concerns within the new regulatory framework. The IAP intends to continue to advocate for the inclusion in the CMRA of an Investor Office or a panel similar to the IAP itself.

Other Issues

Other issues referred to in the Annual Report include proficiency reform and title reform (the latter being aimed at what the IAP sees as designations that mislead investors with respect to advisor qualifications).

For further information, please see 2016 Annual Report of the Ontario Securities Commission’s Investor Advisory Panel (April 2017).

Revisiting the "specified derivatives" rulebook for Canadian investment funds - an old idea whose time has come

Alix d'Anglejan-Chatillon  -

As previously reported, staff of the Ontario Securities Commission (OSC) has issued welcome guidance in the absence of clearly articulated restrictions on the re-hypothecation of collateral supporting specified derivatives transactions in portfolios of prospectus-qualified investment funds.  The guidance, however, also serves to highlight some of the challenges faced by portfolio managers, their counterparties and legal advisers when it comes to managing these derivatives portfolios on a basis that is both compliant with the very technical rulebook governing transactions in “specified derivatives” under National Instrument 81-102 Investment Funds (81-102) and consistent with standard market terms and practices in the broader OTC derivatives industry.

OTC derivatives markets reform is gradually taking shape in the major global derivatives markets.  As the contours of this new regulatory order begin to settle in the United States and Europe, the Canadian Securities Administrators (CSA) and federal regulators continue to piece together a made-in-Canada framework of rules that will mandate, among other changes, derivatives trade data reporting, central counterparty clearing, registration, trading and custody of OTC derivatives and enhanced custody and collateral requirements for non-cleared derivatives.  Here, as in other markets, these new ground rules are being specifically developed to address systemic, counterparty, liquidity, credit and other key risks in the Canadian and cross-border OTC derivatives market and to make that market more transparent, liquid and safe

Against this backdrop, the investment funds branches of the CSA are also working to develop a framework of new rules that would govern prospectus-qualified alternative investment funds. As the regulatory foundation underlying OTC derivative transactions firms up, the opportunity seems particularly ripe for the CSA to repeal the prescriptive, complex and operationally challenging rulebook for “specified derivatives" in favour of a more principles-based prudent portfolio manager standard for the management of the derivatives portfolios of regulated investment funds or, failing that, an updated set of investment restrictions which, with respect to OTC derivatives at least, more closely reflects industry terminology and current market practices.

Re-hypothecation

In its April 2014 edition of the Investment Funds Practitioner, the Investment Funds and Structured Products Branch of the OSC states its view that the collateral deposited by an 81-102 regulated investment fund with a counterparty to support a “specified derivatives” transaction may not be re-hypothecated by the counterparty. 

The guidance states that 81-102 provides a limited "carve-out" from the broader custody rules prescribed by 81-102 for the safekeeping of mutual fund assets.  Under this limited carve-out, assets of the mutual fund may be deposited with a counterparty for the sole purpose of effecting a specified derivatives transaction. In staff’s view, “the counterparty stands in the place of the custodian to safeguard the portfolio assets deposited with it”. 

Although re-hypothecation would reduce transaction costs to the fund, it would, in staff’s view, subject the collateral to “risks inconsistent with the core restrictions” in 81-102 because the collateral carve-out permits “all or substantially all of a fund’s assets to be deposited with a counterparty".  As a practical matter, however, an 81-102 investment fund may not, absent specific discretionary relief, have mark-to-market exposure to a single counterparty greater than 10% of the net asset value of the fund.  It is unlikely therefore that all or substantially all of its assets would be pledged as collateral in favour of a single counterparty.  Staff’s risk assessment on this count might therefore be somewhat overstated.

Other collateral guidance

Staff’s views on re-hypothecation comes with further guidance to the effect that “[g]iven this interpretation, we remind fund managers of their responsibility to ensure that any agreement documenting the OTC derivatives transaction (such as the ISDA or other agreement) prohibits the counterparty from using the collateral for any purpose other than the purpose for which it was originally pledged to the counterparty, namely, the completion of the "particular specified derivatives transaction". Further, our view is that a fund manager must ensure that any documentation evidencing the terms of a specified derivatives transaction: (i) adequately protects the investment fund's portfolio assets from counterparty credit risk, (ii) limits the purpose for which collateral has been deposited by the investment fund to that of the completion of the derivatives transaction consistent with NI 81-102, and (iii) limits the ability of the counterparty to deal with portfolio assets deposited by the investment fund as collateral, in a manner that is consistent with the ability of the fund's custodian to deal with the fund's assets under custody."

Managers of 81-102 governed portfolios may want to revisit their supporting documentation and collateral arrangements in light of this guidance.

Unanswered questions

The guidance on collateral for specified derivatives is welcome but certain longstanding conceptual difficulties with the specified derivatives restrictions remain. These restrictions have been the subject of detailed commentary by market participants (see, for example, the October 17, 2002 and December 19, 2008 comment letters by ISDA).  Certain of these difficulties continue to raise a number of technical compliance issues which complicate the negotiation of standard OTC derivatives arrangements on behalf of an 81-102 regulated mutual fund.  The CSA’s current initiative in developing a regulatory framework for prospectus-qualified alternative investment funds may be an opportune time to rethink the specified derivatives rulebook in the context of current OTC derivatives rulemaking initiatives in Canada, similar regulatory initiatives in the United States (see, for example, Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776 (Aug. 31,2011), 76 Fed. Reg. 55237 (Sept. 7, 2011)) and elsewhere and current market practice.  Making these rules more simple to interpret and apply may be a win-win for all industry stakeholders.

The Investment Funds Practitioner published for April 2015

The Investment Funds and Structured Products Branch of the Ontario Securities Commission today released the April 2015 issue of The Investment Funds Practitioner, which provides an overview of recent issues arising from applications for discretionary relief, prospectuses and continuous disclosure documents filed by investment funds.

In respect of prospectuses, the Practitioner discusses concerns with respect to dual class structures of flow-through limited partnerships. The Practitioner also discloses OSC Staff's expectation that redemptions by ETFs that offer periodic redemptions of their securities at a price determined with reference to the closing market price of those securities be capped at NAV and that disclosure regarding market price redemptions include a statement to that effect. Dealing with mutual funds specifically, concerns include setting the payment of distributions in the form of reinvested units or shares as the default option if securityholders do not specifically request distributions in cash. Further, the Practitioner discusses when additional prospectus disclosure may be requested of the offering expenses of split share companies, and concerns with disclosure in closed-end fund prospectuses that suggest the closed-end fund would be permitted to do certain activities that are now contrary to the amended NI 81-102.

The Practitioner also discusses issues with past performance presentation in Fund Facts and public inquiries in regards to the rehypothecation of collateral for OTC derivatives.

OSC releases draft statement of priorities for 2015-2016

The Ontario Securities Commission today released a draft Statement of Priorities for the financial year ending March 31, 2016. 

The draft statement specifically identifies five regulatory goals for the following year, namely: (i) delivering strong investor protection, including by developing and evaluating regulatory provisions to create a best interest duty, developing targeted regulatory reforms under NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations to improve the advisor/client relationship and implementing pre-sale delivery of Fund Facts for mutual funds; (ii) delivering responsive regulation, including by publishing the results of the disclosure review and continuing to promote transparency and representation of women on boards, and developing and publishing rules to implement new prospectus exemptions, such as the offering memorandum exemption, crowdfunding, rights offering and new reporting requirements regarding exempt market distributions; (iii) delivering effective compliance, supervision and enforcement, including by taking steps to improve the OSC's case management and adjudicative processes; (iv) promoting financial stability, including by implementing rules and a compliance program for OTC derivatives trade reporting and developing a registrant regulation framework for derivatives market participants; and (v) being an innovative, accountable and efficient organization.

The OSC is accepting comments on its draft statement of priorities until June 1, 2015. For more information, see OSC Notice 11-771.

Investment fund modernization project: CSA update on alternative funds framework

Alix d'Anglejan-Chatillon and Darin Renton

The Canadian Securities Administrators yesterday released an update on their planned alternative funds framework for investment funds

As we previously discussed, the CSA announced the implementation of certain aspects of Phase 2 of the Modernization of Investment Fund Product Regulation Project last June. At the time, the CSA stated that an alternative funds proposal would be considered at a later date in conjunction with certain restrictions for non-redeemable investment funds proposed in 2013.

According to the CSA, the previous discussions regarding an alternative funds framework generated a significant response from stakeholders, including in regards to topics such as (i) the attributes of alternative investment funds, including the criteria to be used to differentiate mutual funds and non-redeemable investment funds from alternative investment funds; (ii) naming conventions; (iii) whether alternative investment funds should be permitted to borrow cash and what limits on borrowing should be set; (iv) the use and measurement of leverage; (v) whether short selling should be allowed beyond the limits currently permitted in respect of mutual funds including in respect of cash cover requirements; (vi) other investment restrictions, including in respect of fund-on-fund investing and concentration requirements; and (vii) proficiency standards for representatives selling alternative funds.

In light of the feedback received, the CSA expect to continue consulting with stakeholders until mid-2015, with an expectation of publishing proposed rules towards the end of this year.

For more information, see CSA Staff Notice 81-326.

CSA expect to propose mutual fund risk classification rules this year

The Canadian Securities Administrators yesterday released a status report on their proposed mutual fund risk classification methodology for use in Fund Facts.

As we discussed in a previous post, the CSA proposed a risk classification methodology for the use in Fund Facts documents in December 2013. The proposal, intended to address concerns regarding the lack of standardization in risk disclosure, would classify mutual funds based on the degree to which returns varied over time from the average return.

Ultimately, the CSA received 56 comment letters in response to its proposed methodology, from which a number of general themes were identified, including that: (i) standard deviation be used as the indicator of risk; (ii) standard deviation be calculated using a mutual fund's monthly total returns; and (iii) the risk scale not be expanded from five bands to six.

In light of the feedback received, the CSA expect to publish proposed rule amendments later this year. Whether material changes are made to the original proposals in light of comments, however, remains to be seen. 

For more information, see CSA Staff Notice 81-325.

OSC issues IFRS tip sheet for investment funds

Darin Renton

On January 23, the OSC's Investment Funds and Structured Products Branch released a tip sheet to assist investment funds in completing their first IFRS annual statements.

The guidance specifically discusses required statements of compliance, the need to present an opening IFRS statement of financial position on the face of the financial statements, and disclosure related to a change in accounting policies in the year of IFRS adoption. The Branch is encouraging investment fund issuers to check the tip sheet before filing their first IFRS annual financial statements for the year ending December 31, 2014.

For more information, see IFRS Release No. 4.

TSX proposes new listing regime for closed-end funds and exchange traded and structure products

Philip Henderson and Darin Renton

The regulatory landscape for structured products in Canada continues to evolve with the Toronto Stock Exchange proposing new and tailored listing requirements yesterday for various types of structured entities and products.

Specifically, the amendments to the TSX Company Manual would facilitate the listing of three distinct new categories of issuers or products referred to in the proposal as "closed-end funds", "exchange traded products" and "structured products". The requirements would include tailored minimum listing requirements as well as requirements associated with the general issuance of securities, supplemental listings, management fees, security holder approvals, terminations and voluntary delistings, and continued listing requirements.

Citing the fundamental differences in the trading, liquidity and ability to raise additional funds among the three different product categories, the TSX is proposing certain differing standards for each, such as a minimum market capitalization or IPO raise of $1 million for exchange traded and structured products, and $20 million for closed-end funds.

Comments on the proposals are being accepted until March 16, 2015.

OSC provides update on IFRS disclosure deficiencies for investment funds

Darin Renton

The Investment Funds and Structured Products Branch of the OSC today published its third release in respect of IFRS disclosure deficiencies for investment funds. The release, which provides information regarding the resolution of issues identified in the Branch's first two releases cover such topics as (i) opening IFRS statement of financial position; (ii) IFRS 1 reconciliations; (iii) MRFP disclosure; (iv) auditor involvement with interim financial reports; and (v) regulatory consequences and remedies.

Of particular interest, the release stated that funds that omitted a discussion of the transition to IFRS in their interim MRFP were required to restate and refile the interim MRFP (accompanied by a press release explaining the information being refiled) and were placed on the Refilings and Errors List on the OSC website. Funds that filed an interim financial report that did not include a notice in the absence of an auditor review were placed on the Refilings and Errors List (even in cases where a review was subsequently performed).

As we previously discussed, the Branch published IFRS Release No. 2 last month. According to today's notice, the fourth release in the series, which will take the form of a tip sheet to assist investment funds, will be published in early 2015.

CSA adopt Fund Facts pre-sale requirements for mutual funds

The Canadian Securities Administrators today announced amendments to mutual fund prospectus disclosure rules to implement the pre-sale delivery of Fund Facts. The amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure represent the third stage of the CSA's point of sale disclosure project for mutual funds.

Under the amendments, the most recently filed Fund Facts will have to be delivered to a purchaser before a dealer accepts an instruction for purchase. This delivery requirement will apply to all purchases, including both full service accounts and order execution-only accounts. There will be an exception, subject to certain conditions, where the purchaser instructs the dealer that the purchase must be completed immediately or by a specified time and it is not reasonably practicable to complete pre-sale delivery. In such a case, the Fund Facts will have to be delivered within two days of purchase. This exception will only be available on a purchase by purchase basis and dealers will not be permitted to rely on a blanket consent from the purchaser for post-sale delivery.

Pre-sale delivery requirements will also not apply to subsequent purchases of securities of a mutual fund pursuant to pre-authorized purchase plans where the purchase is not the first purchase under the plan and the dealer provides notice to the purchaser that includes information on how to access and request the Fund Facts. However, the purchaser will not have a right of withdrawal for subsequent purchases.

An initial proposal on pre-sale delivery was made in 2009 as part of the CSA's proposal of amendments related to point of sale disclosure. Amendments were republished earlier this year, and the final form of amendments take into account stakeholder comments.

According to the CSA, pre-sale deliver of Fund Facts will assist investors by making information available to them "at a time that is most relevant to their investment decision."

Subject to Ministerial approval, the amendments come into force March 11, 2015, with the pre-sale delivery requirement coming into effect on May 30, 2016.

OSC publishes The Investment Funds Practitioner for November 2014

Darin Renton

The Investment Funds and Structured Products Branch of the Ontario Securities Commission recently released the November 2014 issue of The Investment Funds Practitioner, which provides an overview of recent issues arising from applications for discretionary relief, prospectuses and continuous disclosure documents filed by investment funds. Below is a summary of a few issues identified.

Prospectuses

Fee-Based Series with Dual Dealer Compensation

According to the Practitioner, Branch staff have recently become aware of certain investment fund series intended for fee-based accounts with a trailing commission embedded in the fund series' ongoing cost. According to staff, embedding a trailing commission in a fee-based series is potentially misleading for investors and this practice may raise the issue of double charging by dealers, contrary to a dealer's general duty to deal fairly, honestly and in good faith with its clients. Staff will require managers of existing funds to transition out of this commission model in a reasonable time period.

Min / Max Offering Bullets

Staff also provided an update on their earlier commentary in respect of the use of bulleted placeholders in preliminary prospectuses. According to the Practitioner, staff expect disclosure of a minimum offering amount in every case, even if the amount is the minimum listing requirement. In respect to a maximum offering size, where an investment fund manager can reasonably anticipate an offering size, that amount should disclosed. In cases where a maximum amount is not disclosed but the investment fund manager has made assumptions about the offering size for the purpose of other disclosure, staff believe those assumptions should be disclosed.

Definition of Mutual Fund Reinterpreted

Staff have revisited a long-standing interpretation of the term “mutual fund”. In order to ensure that the monthly redemption amount of securities of non-redeemable investment funds (NRIF) do not exceed the NAV of a NRIF in contravention of section 10.3(4) of NI 81-102, staff have asked filers to provide that the monthly redemption amount will not exceed the NAV of the NRIF (i.e the monthly redemption amount would be the lesser of (ii) a price determined with reference to the market price and (ii) NAV). Historically, an investment fund that was redeemable with reference to NAV more than once annually was considered to be a mutual fund. Staff’s view is that such disclosure does not mean that the monthly redemption amount is being calculated with reference to the NAV and a NRIF whose prospectus includes such disclosure will not be considered by staff to be a “mutual fund”.

T+2 Settlement Cycle for European Securities

Further guidance was also provided in respect of disclosure regarding monthly redemption amounts regarding closed-end funds, currency hedging in investment objectives, the T+2 settlement cycle for European securities and securities lending.

Continuous Disclosure

According to the Practitioner, Branch staff are currently conducting targeted reviews focusing on asset classes that may be at risk of liquidity issues. Funds with exposure to high yield fixed income, small cap equity and emerging market issuers include those on which the Branch has focused. Once the reviews are complete, the Branch intends to publish their findings and guidance.

Branch staff have also focused their ongoing continuous disclosure reviews on fixed income funds with exposure to senior loans. As a result of the reviews and on recent prospectus filings, staff have focused on textbox disclosure, management liquidity assessments and stress testing and scenario analysis.

Disclosure of Auditor Review of Interim Financial Report: OSC Finds Deficiencies

Darin Renton - 

Last week, the OSC's Investment Funds and Structured Products Branch released a notice reminding investment fund issuers that, where an auditor has not performed a review of an investment fund's interim financial report, s. 2.12 of NI 81-106 requires the report to be accompanied by a notice indicating that fact.

In the course of its IFRS review, Branch staff identified non-compliance with this notice requirement. While the instrument does not specify the form of notice, the Companion Policy states that the notice should be on a separate page appearing immediately before the interim financial report. According to Branch staff, a lack of the required notice implies that a review was conducted and that the auditor did not express a reservation. Marking interim financial reports as "unaudited" does not fulfill this requirement.

In cases where the reports appeared to have been reviewed by the auditor, the Branch found a lack of clarity in respect of whether the reviews were in accordance with section 7060 Auditor Review of Interim Financial Statements of the CPA Canada Handbook.

As such, Branch staff have requested that investment fund issuers refile their interim financial reports for the period ending June 30, 2014 with the required notice and accompanied by a news release explaining the information being filed. Branch staff also reminded investment fund managers that a deficiency in the required disclosure could ultimately result with the issuer being placed on the default list.

This is the second notice released by the Branch in connection with its review the first IFRS interim financial reports for the period ended June 30, 2014. The first notice was released in October. The OSC is continuing to monitor compliance with requirements regarding the disclosures respecting auditor review and may release further notices as necessary.

Amendments to registrant regulatory framework place restrictions on exempt market dealers, limit availability of registration exemptions and harmonize sub-adviser exemption

Jeffrey Elliott, Alix d’Anglejan-Chatillon, Kenneth G. Ottenbreit and Terence W. Doherty -

The Canadian Securities Administrators recently published final amendments to NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations which will have a significant impact on the registration requirements for dealers, advisers and investment fund managers (the Amendments) and include (i) restrictions on the activities that exempt market dealers may conduct, including a prohibition on brokerage activities; (ii) limits on the availability of certain registration exemptions for registrants; (iii) the addition of an adviser registration exemption for trades through a registered dealer; (iv) a harmonized adviser registration exemption for international sub-advisers; and (v) exemptions from certain registration requirements for registered sub-advisers.

Restrictions on Exempt Market Dealers (EMDs)

The Amendments will significantly restrict the activities that may be undertaken by EMDs. Notably, an EMD will be prohibited from conducting brokerage activities and will only be permitted to act as a dealer when trading a security that would be exempt from the prospectus requirement if such trade were to be a distribution provided that the security is not listed, quoted or traded on a marketplace unless the trade is made in reliance on a further prospectus exemption. Interestingly, the definition of “marketplace” is not limited to marketplaces in Canada, and as such, an EMD will be prohibited from trading securities that are listed on a foreign exchange. An EMD will still be permitted to act as a dealer by trading a security distributed under a prospectus exemption, whether or not a prospectus is filed, and to act as an underwriter in respect of a distribution made under a prospectus exemption. However, an EMD will no longer be able to receive an order from a client to sell a security that was acquired by the client in these circumstances, nor may it conduct activities or solicitations in furtherance of receiving such orders. Amendments to Companion Policy NI 31-103 also clarify that distributions of securities offered under a prospectus and the participation in the resale of securities on a marketplace, including the establishment of an omnibus account with an investment dealer and trading securities through that account, are prohibited activities that should be conducted by an investment dealer.

Limits on Registration Exemptions

Another significant Amendment is that a firm currently registered as a dealer (EMD, restricted dealer or investment dealer), adviser (portfolio manager, restricted portfolio manager) or investment fund manager, will no longer be able to rely on the exemptions from registration in the local jurisdiction if the firm’s existing registration in the local jurisdiction permits the firm to act in the capacity for which the exemption is provided. As such, dealers registered in one province, for example, will no longer be permitted to rely upon a dealer registration exemption (i.e., the international dealer exemption) in such jurisdiction.

This restriction only applies to the prescribed exemptions set out in NI 31-103. Thus, exemptions such as the specified debt exemption (section 8.21 of NI 31-103) and the short term debt exemption (section 8.22.1 of NI 31-103) which have similar counterparts set out in the Securities Act in Ontario and/or OSC Rule 45-501 Ontario Prospectus and Registration Exemptions will continue to be available to firms in Ontario.

Trades Through a Registered Dealer 

A new dealer registration exemption will be introduced pursuant to the Amendments that permits a registered adviser, or an advising representative or associate advising representative on behalf of a registered adviser, to conduct trading activities that are incidental to its providing advice to a client, if the trade is made through a dealer registered in a category that permits the trade or a dealer operating under an exemption from the dealer registration requirement.

Additionally, the current dealer registration exemption permitting firms to trade securities through a registered dealer or to a registered dealer purchasing as principal has been clarified to indicate that it will no longer be available to those who solicit or contact directly any purchaser of securities in relation to a trade. This exemption now prohibits the firm seeking to rely on it from having any contact with the prospective investor, regardless of the nature of the contact. The CSA have noted that this exemption is only intended to permit acts in furtherance of a trade that do not involve soliciting or direct contact in relation to that trade. Meetings with clients that do not involve acts in furtherance of that trade and presentations about brands or strategies with no mention of specific securities may not be solicitation or direct contact in relation to that trade. The execution of a trade through or to an appropriately registered dealer by a dealer located in another jurisdiction would, however, qualify under this exemption.

International Sub-Adviser Exemption

The adviser registration exemption currently available in Ontario and Quebec has been incorporated in NI 31-103 and will be harmonized across the other jurisdictions. As was required under this exemption in Ontario and Quebec, a sub-adviser will not be required to register as an adviser provided that the obligations and duties of the sub-adviser are set out in a written agreement with the registered adviser or dealer and the registered adviser or dealer has entered into a written agreement with its clients on whose behalf investment advice is or portfolio management services are to be provided and agreeing to be responsible for losses that arise out of certain failures on the sub-adviser’s part. The sub-adviser must also be located in a foreign jurisdiction (the foreign jurisdiction requirement, be registered in a category of registration (or exempt from registration) and engaged in the business of an adviser in such foreign jurisdiction. The foreign jurisdiction requirement is a departure from the exemptions currently in effect in Ontario and Quebec, and it effectively precludes reliance on the exemption by unregistered Canadian-resident sub-advisers located in another Canadian jurisdiction. Unregistered sub-advisers located in Canada may need to consider the need to register as an adviser or seek special exemptive relief. In the companion policy to NI 31-103, the CSA have expressed their expectation that registrants taking on liability for a sub-adviser’s activities will conduct and maintain records of appropriate due diligence and ensure the investments are appropriate for the registrant’s clients.

Registered Sub-Advisers

In accordance with the Amendments, a registered sub-adviser will be exempt from certain requirements in respect of its activities, including requirements relating to the identification of conflicts of interests, referral arrangements and account statements provided that its obligations and duties are set out in a written agreement and the registered adviser or dealer has entered into a written agreement with its clients agreeing to be responsible for losses that arise out of certain failures on the sub-adviser’s part. These exempt requirements are not considered necessary as the sub-adviser’s client is another registrant. The CSA expects the registrant and sub-adviser to conduct and maintain records of their transactions and due diligence as described above.

Other Amendments

Other Amendments include:

  • CCO Experience Requirements for EMDs: in addition to passing the Exempt Market Products Exam or the Canadian Securities Course Exam and passing the PDO Exam or the Chief Compliance Officer’s Qualifying Exam, an EMD will also be required to have gained 12 months of relevant securities industry experience in the 36-month period before applying for registration;
     
  • Short-Term Debt Exemption: the codification of a short-term debt exemption that is currently available in the majority of Canadian jurisdictions which permits specified financial institutions to trade short-term debt instruments with permitted clients. This exemption will be available in all jurisdictions except for Ontario where there are alternative exemptions that may be available for trading in short-term debt instruments, including exemptions in section 35.1 of the Securities Act (Ontario) and section 4.1 of OSC Rule 45-401 Ontario Prospectus and Registration Exemptions;
     
  • Delivery of Subordination Agreement: registered firms that enter into a subordination agreement must deliver the executed agreement to the securities regulatory authority within a prescribed period of time; and
     
  • Reporting Requirements for Acquisition of Foreign Registrants: a registrant will be required to provide written notice to the regulator if it proposes to acquire 10% or more of the voting securities or securities convertible into voting securities of a registrant in any foreign jurisdiction or all or a substantial part of the assets of a firm registered in any foreign jurisdiction.

Effective Date

The Amendments which are being made to NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, NI 33-109 Registration Information, NI 52-107 Acceptable Accounting Principles and Auditing Standards, their related companion policies and OSC Rules 33-506 (Commodity Futures Act) Registration Information and 35-502 Non-Resident Advisers, are generally expected to come into effect on January 11, 2015 with the prohibition on EMDs engaging in brokerage activities being subject to a transition period ending July 11, 2015.

OSC sets out IFRS disclosure deficiencies for investment funds

Last week, the OSC's Investment Funds and Structured Products Branch released a notice setting out deficiencies identified by branch staff in their preliminary review of IFRS interim financial reports for the period ending June 30, 2014.

According to staff, recurring deficiencies in IFRS filings include (i) missing IFRS 1 reconciliations; (ii) missing opening IFRS statements of financial position; and (iii) missing management report of fund performance (MRFP) disclosure.

According to the branch, these deficiencies will be addressed in comment letters to investment fund managers. The notice also reminds investment fund issuers that non-compliance could result in the issuer being added to the default list.

CSA undertake research on mutual fund fees

On September 19, the Canadian Securities Administrators announced two research initiatives to review Canada's mutual fund fee structure. The first will involve collecting and reviewing data on whether sales and trailing commissions influence sales, while the second will include a literature review to consider whether the use of fee-based as opposed to commission-based compensation changes the nature of advice and investment over the long term.

As we've previously discussed, the CSA released a discussion paper in December 2012 to solicit feedback on the structure of mutual fund fees in Canada, while a December 2013 status report identified a number of key themes emerging from the consultation process. 

Results of the research are expected to be publicly released in the first quarter of 2015. 

Ministerial approval granted to Phase 2 of investment fund modernization

Ministerial approval has now been granted to amendments to implement certain aspects of Phase 2 of the Modernization of Investment Fund Product Regulation Project, which includes, among other things, amendments to National Instrument 81-102 Mutual Funds.

The mandate of Phase 2 involves generally addressing the regulatory gap between non-redeemable investment funds and mutual funds by focusing on imposing certain core operational requirements on publicly offered non-redeemable investment funds that are generally analogous to the requirements applicable to mutual funds.

As we've previously discussed, the final amendments come into effect on September 22, with implementation to occur over the next few years.

ASC to clarify how investment fund rules apply to MIE funds

In late August, the Alberta Securities Commission staff published a notice advising that they intend to ask the ASC to issue a designation order to clarify how rules applicable to investment funds apply to mortgage investment entities that are investment funds.

According to the staff notice:

Because an Operational MIE may be an investment fund under the Act but in circumstances, other than relating to the registration requirement, it is considered more appropriate that such MIEs be subject to the rules applicable to non-investment funds, ASC staff intend to request that the Commission issue a designation order designating Operational MIEs to not be non-redeemable investment funds.

The designation order is expected to provide that, except for the registration requirement, Operational MIEs are designated not to be a non-redeemable investment fund.

The designation order is expected to be published sometime next week. For more information, see ASC Staff Notice 81-701.

OSC publishes The Investment Funds Practitioner for July 2014

Darin Renton -

The Investment Funds and Structured Products Branch of the Ontario Securities Commission recently released the July 2014 issue of The Investments Funds Practitioner, which provides an overview of recent issues arising from applications for discretionary relief, prospectuses and continuous disclosure documents filed by investment funds. Below is a summary of a few issues identified.

Structured Products

According to the Practitioner, Branch staff have noticed that some pricing supplements for linked notes whose reference asset is a fund or ETF do not disclose the fees associated with the ownership of the reference asset. As such, funds are reminded to disclose any fees charged by the reference asset that affect the return of the notes.

Meanwhile, the Practitioner states that Branch staff are increasingly scrutinizing linked notes that have autocall features. Staff are specifically concerned that autocall notes could be mistaken for, and sold as, alternatives to fixed income or money market securities. Staff are thus now asking that the front page of autocall note prospectus supplements include a textbox disclosing the existence of downside risk and that such notes are not designed to be alternatives to fixed income or money market instruments.

Applications

According to the Practitioner, Branch staff have recently noticed applications that contemplate the merger of funds with significantly different investment objectives. In such cases, staff have required filers to make representations in respect of the reasons for the merger, the process undertaken to choose the continuing fund, and the reasons why the merger is in the best interests of securityholders. According to Branch staff, boiler-plate statements respecting such things as the reduction of expenses and increased diversification are not sufficient.

Prospectuses

In respect of prospectuses, Branch staff have noticed that some recent preliminary simplified prospectuses disclosed the ability of fund managers to address short-term trading by preventing an investor's account from further transactions for a certain period of time through actions that included the suspension of redemptions. The Practitioner reminds fund managers that they may generally not suspend redemptions except in certain specific circumstances.

Further, Branch staff take the position that a default rate feature attached to the direct payment of ongoing dealer service fees is inconsistent with the negotiation of the service fee. As such, Branch staff expect that new funds will not have a default rate feature while in respect of renewal prospectuses, Branch staff will ask fund managers for a reasonable transition period for the removal of the default rate feature.

Continuous Disclosure

The Practitioner provides the findings of a recent review of investment funds with high management expense ratios. The sampled funds either had fund managers that absorbed a significant level of expenses in order to present MERs after absorption consistent with industry average (in which case investor expectations should be managed to clarify that absorptions could cease in the future), or had relatively high MERs due to their small size (in which case staff expect fund managers to consider all options to reduce the MER).

The Practitioner also stated that Branch staff intend to conduct a continuous disclosure review of the first IFRS financial statements disclosed by funds (generally, due by August 29, 2014), and will be asking filers general questions in respect of implementation issues and justifications of accounting treatments under IFRS.

Process Matters

The Practitioner also advised fund managers against placing too much reliance on the materiality threshold of $50 per investor in respect of miscalculated and overpaid fees requiring repayment to investors. According to Branch staff, fund managers "should use their judgement in determining whether a $50 threshold is appropriate in their particular situation and be mindful of their statutory duty as fund manager when selecting a materiality threshold."

Branch staff also reminded filers that no substantive changes should be made to a prospectus after the SEDAR project status is "clear for final". According to the Practitioner, filers have asked staff to update the project status "clear for final" even where further substantive changes were expected.

MFDA publishes guidance on use of investor questionnaires

Earlier this week, the MFDA released a discussion paper intended to provide guidance on the use by mutual fund dealers of investor questionnaires to assist in the know-your-client process. Among other things, the paper discusses topics such as designing an investor questionnaire, implementation considerations and the benefits and limitations of employing a questionnaire.

For more information, see MFDA Bulletin #0611-C.

Investment fund modernization: Phase 2 implementation to start in September of 2014

The Canadian Securities Administrators today announced the adoption of final amendments that will implement certain aspects of Phase 2 of the Modernization of Investment Fund Product Regulation Project.  The mandate of Phase 2 involved generally addressing the regulatory gap between non-redeemable investment funds and mutual funds by focusing on imposing certain core operational requirements on publicly offered non-redeemable investment funds that are generally analogous to the requirements applicable to mutual funds.

The final amendments to be adopted as of September 22, 2014 stem from proposed amendments published last year, and will involve the imposition of core investment restrictions for non-redeemable investment funds while also enhancing disclosure requirements regarding securities lending activities by investment funds. The following is a summary of some of the final amendments that are set to come into force, which we will review in further detail in subsequent posts.  

Notably, the final amendments do not extend to the creation of a more comprehensive alternative funds framework (planned to be effected through an overhaul of National Instrument 81-104 Commodity Pools).  As previously announced by the CSA,  the “alternative funds proposals” have been deferred to allow for further review, along with related restrictions that were proposed with respect to investments in physical commodities, short selling, the use of derivatives and borrowing cash.

The final amendments that have been approved include investment restrictions relating to investment concentration and control, investments in real property, loan syndications and mortgages, the use of fund-of-fund structures and extending the framework in respect of securities lending, repurchase and reverse repurchase transactions currently found in NI 81-102 Mutual Funds to closed-end funds.

Other elements of NI 81-102 that will be extended to closed-end funds include requirements relating to conflicts of interest, and securityholder and regulatory approval of fundamental changes, which include additional approval requirements that expand upon those currently found in NI 81-102.  Restrictions will also be imposed in respect of further issuances of securities and upon funds that issue warrants and rights.

The amendments also introduce new disclosure requirements intended to better highlight the costs and returns of an investment fund's securities lending activities, including in respect of revenue sharing arrangements between a fund and its securities lending agent. To that end, the amendments will require disclosure, in the notes to financial statements, of a reconciliation of the gross amount generated from the securities lending transactions of the investment fund to the revenue from securities lending disclosed in the statement of comprehensive income disclosed under s. 3.2 of NI 81-106 Investment Fund Continuous Disclosure.

Proposed amendments were first published by the CSA in March 2013. In response to comments received, the CSA have made changes to the final version of the amendments, including by relaxing some of the originally proposed investment restrictions and introducing the securities lending disclosure requirements described above.

While the amendments generally come into force on September 22, 2014, existing funds that are reporting issuers will have until September 2015 to comply with the relevant amendments concerning securities lending. The transition period for various of the other changes extends into 2016.

OSC provides guidance for investment fund managers following targeted operational review

Staff of the OSC's Compliance and Registrant Regulation Branch today released guidance intended to assist investment fund managers in satisfying the duty to act honestly, in good faith and in the best interest of their funds.

The guidance follows a recent targeted review of a sample of large investment managers that focused on compliance with regulatory requirements for key operational areas such as minimum working capital requirements and custody, securityholder reporting, trust and fund accounting, oversight of service providers, conflicts of interest and sales practices.

Ultimately, branch staff identified a number of areas where deficiencies were found, specifically in respect of (i) sales practices, leading to guidance in respect of meeting the "primary purpose" test and the reasonability of costs; (ii) the allocation of expenses to investment funds; (iii) mutual fund borrowings, including in respect of the interpretation of the term "all borrowings"; (iv) prohibited cross trades; and (v) outsourcing and oversight of service providers.

The staff notice ultimately provides guidance in the form of answers to common scenarios and suggested best practices.

For more information, see OSC Staff Notice 33-743.

MFDA establishes whistleblower program

Earlier this year, the Mutual Fund Dealers Association of Canada (MFDA) announced the establishment of a whistleblower program to receive information from those with knowledge or evidence of potential wrongdoing by MFDA members or approved persons. According to the MFDA, the program will help it identify and respond to misconduct and reduce harm to the public.

CSA propose Fund Facts pre-sale delivery requirements

The Canadian Securities Administrators today published proposed amendments to mutual fund prospectus disclosure rules that would implement requirements regarding the pre-sale delivery of Fund Facts. The amendments represent the third stage of the CSA's point of sale disclosure project for mutual funds.

Under the proposed amendments, the most recently filed Fund Facts would have to be delivered to a purchaser before a dealer accepts an instruction for purchase. Delivery would not be required, however, if the purchaser had already received the most recently filed Fund Facts. There would also be an exception, subject to certain conditions, where a purchaser indicated a desire to complete the purchase immediately or by a specified time, and it was not practicable for the dealer to complete pre-sale delivery. In such a case, the Fund Facts would have to be delivered within two days of purchase.

Pre-sale delivery requirements would also not apply to subsequent purchases of securities of a mutual fund pursuant to pre-authorized purchase plans so long as the dealer provided initial and subsequent annual notices to the purchaser that included information on how to access and request the Fund Facts and that the purchaser would not have a right for withdrawal of the purchase.

An initial proposal on pre-sale delivery was made in 2009 as part of the CSA's initial proposal of amendments related to point of sale disclosure. The proposal released today addresses comments received from stakeholders and, according to the CSA, simplifies the proposed approach to pre-sale delivery.

According to the notice, the CSA is also currently working on the mutual fund risk classification methodology published in December 2013, as well as the development of a summary disclosure document and delivery requirements for ETFs, which is expected to be published later this Fall.

The CSA is proposing a one-year transition period following the effective date of the amendments. Comments on the proposal are being accepted until May 26, 2014.

Anti-loss trading rules may impact investment trusts

Katy Pitch and Lindsay Gwyer -

For several decades, corporations have been subject to the Income Tax Act’s “loss streaming” rules, which restrict a corporation’s ability to carry forward losses and certain credits following an acquisition of control of the corporation. In the absence of these rules, a profitable corporation would be able to acquire a corporation with accrued losses, amalgamate with it, and carry the accrued losses forward to shelter future income. The loss streaming rules limit the effectiveness of this kind of transaction in a number of ways, including by preventing a corporation from carrying forward capital losses after an acquisition of control, and by only allowing non-capital losses to be carried forward and deducted against income from the same business or a similar business as the business which generated the losses.

While these rules historically applied only to corporations, recent legislative changes have extended their applicability to trusts. We would like to draw readers’ attention to a number of consequences of the amendments, particularly as they may affect investment fund trusts.

The new “Loss Restriction Rules” 

The extension of the loss-streaming rules to trusts was announced by the Minister of Finance in Budget 2013. Legislation implementing the necessary changes (the Loss Restriction Rules) was enacted on December 12, 2013, retroactively to March 21, 2013. Although the Loss Restriction Rules are targeted at preventing a very specific type of transaction, they will apply broadly to all trusts. Significantly, they could have important implications for the everyday operation of investment funds that are structured as trusts.

The Loss Restriction Rules apply where a trust is subject to a “loss restriction event”. A loss restriction event occurs where a person becomes a majority-interest beneficiary of the trust or a group becomes a majority-interest group of beneficiaries of the trust. A majority-interest beneficiary of a trust is a beneficiary (including a partnership) that, together with all affiliated persons, has an interest in the income or capital of the trust that is greater than 50% of the fair market value of all the interests in the income or capital of the trust. Generally speaking, a majority-interest group of beneficiaries is a group of beneficiaries that, if all their interests were aggregated, would hold greater than 50% of the fair market value of all the interests in the income or capital of the trust, provided that this threshold would still be met if any member of the group were not a member of the group. Several other supporting and interpretive rules exist, including rules intended to prevent transfers between certain affiliated persons from giving rise to a loss restriction event. A loss restriction event will not be triggered when a person ceases to be a majority-interest beneficiary. 

Consequences of the new rules

When a trust becomes subject to a loss restriction event, several consequences will occur which can have material significance for an investment fund:

  • Expiry and use of certain losses: on a loss restriction event, any accrued net capital losses of a trust will expire and any net capital losses realized after the event cannot be carried back to a time before the event. As well, the trust will be forced to immediately recognize any accrued by unrealized losses on non-depreciable capital property. If the trust changes its business subsequent to the loss restriction event, it may be unable to deduct business losses accrued prior to the loss restriction event.
     
  • Deemed year-end: on a loss restriction event, the current taxation year of the trust will be deemed to end at the beginning of the day on which the event occurred. From a compliance perspective, the trust will need to make its regular end-of-year filings at the end of the short taxation year. This will include filing its T3 Return and issuing T3 slips to unitholders within 90-days of the deemed year end. A mutual fund trust which is subject to a loss restriction event in its first taxation year will also need to ensure that it files the election to be a mutual fund trust from the beginning of its first taxation year in its tax return for the short taxation year. The short taxation year will also shorten the amount of time that the trust has to meet the requirements to qualify as a mutual fund trust, since the requirements must be met within 90-days of the end of the trust’s first taxation year (provided the proper election is filed). As well, investment funds will need to consider whether their automatic distribution mechanism (which generally distributes all income remaining at the end of a taxation year to unitholders to ensure that the fund itself does not become liable to tax) will apply to cause a distribution after a short taxation year. Similarly, assuming that the additional distribution is normally made in units, it will be necessary to ensure that the distribution is automatically followed by a consolidation of units or a recalculation of the net asset value of the outstanding units, as appropriate.     
     
  • Mergers: the new rules will create complexities in the context of mergers (both taxable and tax-deferred) between trusts, and may restrict the ability to carry forward losses of one or more of the predecessor trusts.

Conclusion

The Loss Restriction Rules are detailed and complex, and could have significant implications for investment funds that operate as trusts and that become subject to a loss restriction event.  For existing funds, managers should consider whether, based on subscriptions, trades and redemptions of units, a person or group of persons could acquire more than 50% of the capital or income entitlements of the trust.  To be proactive, on the creation of a trust, measures may need to be taken regarding ownership restrictions (similar to restrictions commonly found in a declaration of trust for a mutual trust which prohibit non-residents from owning a majority of the trust units) to ensure that a loss restriction event can be avoided.  In addition, managers should take measures to ensure that, should the trust become subject to a loss restriction event, it will be able to deal with the resulting administrative requirements.

OSC publish review of activities and initiatives related to funds in 2013

The Ontario Securities Commission today published a staff notice summarizing key initiatives and activities impacting investment fund issuers and the fund industry.

Specifically, the notice reviews the status of a number of policy initiatives, including with respect to, among other things, the transition to IFRS, mutual fund fees, point of sale and risk classification methodology for Fund Facts, and the modernization of investment fund product regulation.

The OSC also identifies a number of emerging trends over the past year, including an increase in the number of prospectus offerings that proposed to invest substantially all their assets in a pool of mortgages as well as an increase in the use of derivatives to offer more efficient investment exposure to areas that are more difficult to reach through direct investments.

The staff notice also includes a discussion of findings emerging from OSC staff's review of prospectus and continuous disclosure, including in respect of risk ratings in Fund Facts and sales communications and advertising. With respect to the latter issue, OSC staff found that while funds were generally compliant with disclosure requirements related to sales communication, some communication did not contain all the information required.

For more information, see OSC Staff Notice 81-723.

IFRS for investment funds received Ministerial approval

Regulatory changes requiring investment funds to transition to IFRS for financial years beginning on or after January 1, 2014 have now received Ministerial approval in Ontario and Quebec.

CSA provide status update on mutual fund fee structure consultation

The CSA yesterday released a status report on their mutual fund fee consultation initiative. As we discussed last year, the CSA released a discussion paper in December 2012 identifying investor protection and fairness issues resulting from the Canadian mutual fund fee structure and soliciting feedback on the current structure.

Today's report identifies a number of key themes emanating from the consultation process from the point of view of industry and investors. According to industry stakeholders (i) there is no evidence of investor harm warranting a change of the current fee structure; (ii) a ban on embedded compensation would have unintended consequences, including with respect to reduced access to advice for small retail investors and the creation of an unlevel playing field among competing products; and (iii) the impact of domestic and international reforms should be assessed prior to moving ahead with further proposals.

From the point of view of investors, (i) embedded adviser compensation should be banned as it causes a misalignment of interests that impacts investor outcomes; (ii) investors should have, at a minimum, the true choice to not pay embedded commissions; (iii) a best interest duty for advisers should be implemented; and (iv) adviser proficiency requirements should be increased and the use of titles regulated.

The CSA also referred to the status report on the best interest duty, as a number of key messages were found to be similar to those emerging from that consultation process. According to the CSA, the similarity between the two initiatives suggests a need to coordinate policy assessments going forward, and the CSA expect to communicate any potential regulatory actions in the coming months.

Investment Funds Practitioner published for November 2013

Last week, the Investment Funds Branch of the Ontario Securities Commission released the November 2013 issue of the Investments Fund Practitioner. The publication provides an overview of recent issues identified by the Branch arising from prospectus filings, exemptive relief applications and continuous disclosure documents filed by investment funds.

Prospectuses

Of particular interest, the Practitioner states that Branch staff are currently focusing on three priority areas in their prospectus reviews, namely fees and expenses (including whether explanations are in clear and plain language), investment objectives and strategies (including the provision of meaningful information for investors), and conflicts of interest. According to the Practitioner, staff's intention is to encourage more consistent disclosure and promote clear, accurate and understandable disclosure, rather than boilerplate language.

The Practitioner also took note of the use of the term "guarantee", reminding filers that in cases where a fund offers a guarantee, the prospectus and Fund Facts disclosure should allow investors to fully understand the unique characteristics of the fund, the fund's investment objectives, the fund's suitability for investors, the nature of the guarantee and the consequences of early redemptions or termination of the fund. Further, Branch staff expect that Independent Review Committee and shareholder approval be obtained prior to early termination of the guarantee.

The Practitioner also notes that Branch staff have recently seen simplified prospectuses where issuers have identified, in the annual information form, companies that are principal holders of the funds as "Investor A", "Investor B", etc. While staff allow that individuals for principal holders of funds to be referred to as such in a prospectus, privacy concerns with respect to individuals do not apply to companies. As such, absent exemptive relief, the names of companies that are principal holders of a fund must be disclosed in the AIF of the simplified prospectus.

The Practitioner also expressed concern in respect to the marketing materials of scholarship plans and with the possible dilution of securityholders due to recirculation agreements in the case of closed-end funds.

Continuous Disclosure

According to the Practitioner, Branch staff recently conducted targeted continuous reviews of risk ratings of mutual funds disclosed in the Fund Facts. On this point, staff noted that, in the case of mutual funds in the same fund family that had both a currency hedged fund and an unhedged fund that provided exposure to the same underlying fund or portfolio, fund managers typically rate both the currency hedged fund and the unhedged fund with the same risk rating despite the difference of volatility of past returns between the funds. In staff's view the risk ratings for currency hedged funds should be determined separately from the unhedged counterparts and staff also reminded filers that a change to a mutual fund's risk level is a considered a material change under securities legislation.

The Practitioner also noted that, as we've discussed previously on this blog, the CSA have adopted January 1, 2014 as the date for investment funds to transition to IFRS.

Finally, Branch staff reminded filers that blacklined versions of Fund Facts filed for review must show changes, including the text of deletions and additions from the previously filed version. Changes must be clearly shown and should not be shown by way of comment bubbles, and side-by-side comparisons are not considered acceptable.

OSC outlines compliance deficiencies in annual report

The OSC Compliance and Registrant Regulation Branch's Annual Summary Report for Dealers, Advisers and Investment Fund Managers was published today. The report summarizes new and proposed rules and initiatives impacting registrants and reviews current trends in respect of compliance deficiencies and registration issues.

Of particular interest are the OSC's findings in respect of its compliance review process. Specifically, during fiscal 2013, compliance reviews resulted in 38% of registered firms reviewed requiring enhanced compliance (as compared to 34% in 2012), while 52% of registered firms reviewed requiring "significantly enhanced compliance" (as compared to 47% in 2012).

Deficiencies identified during the review process in respect of all registrants included: (i) non-compliance with KYC, KYP, suitability and accredited investor requirements; (ii) inadequate compliance systems and ultimate designated persons and chief compliance officers not meeting their responsibilities; (iii) inadequate or lack of annual compliance reports; (iv) failures to provide notice of ownership changes or asset acquisitions; (v) inaccurate calculations of excess working capital; (vi) insufficient working capital and failure to report capital deficiency; (vii) financial statements not prepared in accordance with NI 52-107; (viii) inadequate relationship disclosure information; and (ix) incorrect calculation of capital market participation fees.

Specific deficiencies identified in respect of EMDs included (i) conflicts of interest when selling securities of related or connected issuers; (ii) inadequate disclosure of conflicts of interest; and (iii) inadequate risk disclosure information. With respect to portfolio managers, reviews found (i) inadequate personal trading policies; (ii) inadequate investment management agreements; and (iii) inadequate supervision of advising representatives and research analysts. The OSC also conducted a "sweep review" of newly-registered PMs in Ontario, which identified deficiencies in respect of, among other things, misleading marketing practices and inadequate relationship information to clients.

In respect of investment fund managers, deficiencies included (i) inappropriate expenses charged to funds; (ii) inadequate disclosure in offering memoranda; (iii) inadequate oversight of outsourced functions and service providers; and (iv) non-delivery of net asset value adjustments.

The report ultimately provides suggested practices to assist firms in addressing the deficiencies identified. The OSC recommends that registrants use the report as a self-assessment tool to strengthen their compliance with applicable regulations and make changes as necessary. For more information, see OSC Staff Notice 33-742.

CSA adopt transition date for investment funds to move to IFRS

The Canadian Securities Administrators announced yesterday that they have finalized changes that will transition financial reporting for investment funds to IFRS.

While reporting issuers and registrants generally were required to transition as of January 1, 2011, the transition date for investment funds was deferred in order to allow for the International Accounting Standards Board’s (IASB’s) exception from consolidation for investment companies to be in place prior to the transition.  Without this exception, investment funds would have been required to consolidate investments that they controlled, resulting on potentially confusing disclosure given that their portfolios were historically shown at fair value. This issue was resolved under the IASB's Investment Entities (Amendments to IFRS 10, IFRS 12 and IAS 27) issued on October 31, 2012, which provides the required exception. According to the CSA, the definition of “investment entity” in IFRS 10 should capture, and therefore resolve the issue for, most investment funds. They do acknowledge, however, that it is possible that it may not capture all of them.

Investment funds will therefore be required to transition to IFRS for financial years beginning on or after January 1, 2014. Amendments have also been made to cover terminology differences between Canadian GAAP and IFRS and to reflect changes to financial statement presentation and will affect NI 81-106, NI 81-101, NI 81-102, NI 81-104 and the investment fund form of prospectus under Form 41-101F2.

The amendments include non-material changes made to the CSA's initial proposal published in October 2009 to reflect comments received from stakeholders. Assuming Ministerial approvals, the amendments come into force on January 1, 2014.

Alternative investment fund managers regulations 2013 - disclosure and reporting requirements for Canadian fund managers

Jeffrey Keey and Stanley McKeen -

As we initially discussed in an earlier post, Canadian managers of private equity, venture capital and other fund structures that are not regulated as “investment funds” under Canadian securities laws may, in the UK, be subject to marketing and related restrictions imposed by the Alternative Investment Fund Managers Regulations 2013 (the UK Regulations) when marketing alternative investment funds (AIFs) to professional investors in the UK pursuant to the UK’s national private placement regime. 

The UK Regulations, which implement the European Alternative Investment Fund Managers Directive (the Directive), came into force on 22 July 2013. As required by the Directive, the UK Regulations effectively regulate a much broader array of fund structures than conventional alternative investment funds. While EU member states were required to implement the Directive prior to July 22, 2013, only 12 of 31 EU member states had completed full legislative transposition within the deadline. Many of these 12 member states will provide transitional relief from the obligations imposed by the Directive for a one (and in some cases two) year period.

Summary of Obligations imposed by the UK Regulations

Pursuant to the UK Regulations, Canadian alternative investment fund managers (Fund Managers) may market an EU AIF or a Canadian (or other non-EU) AIF to professional investors under the UK’s private placement regimes, provided the Canadian Fund Manager registers with the UK Financial Conduct Authority and complies with the following requirements in the UK Regulations (described in further detail below):

  • transparency requirements, including the provision of:
    • an annual report
    • information to investors prior to investment;
    • on-going disclosure to investors;
    • on-going reports to regulators;
  • portfolio company disclosure requirements, including:
    • disclosure of acquisitions of “control”;
    • disclosure of financing arrangements when “control” is acquired; and
  • asset stripping restrictions.

The UK Regulations also require that Canada not be listed as a Non-cooperative Country and Territory by the Financial Action Task Force and that cooperation agreements have been entered into between the relevant Canadian regulators and the FCA. In Canada, the Ontario Securities Commission, the Autorité des marchés financiers, the Alberta Securities Commission and British Columbia Securities Commission have entered into memorandums of understanding with 34 European Regulators, including the UK’s FCA. In Ontario, the MOU is subject to approval by the Ontario Minister of Finance.

Small Fund Manager Exemptions

While Small Canadian Fund Managers (as defined below) are exempt from the majority of the UK Regulations’ requirements, they must still register with the FCA. Small Fund Managers are defined as those Fund Managers that, either directly or indirectly, through a company with which the Fund Manager is linked by common management or control, or by a substantive direct or indirect holding (i) manage portfolios of AIFs whose assets under management either do not exceed €500 million in total (in cases where the portfolios of AIFs consist of AIFs that are unleveraged and have no redemption rights exercisable during a period of five years following the date of initial investment in each AIF); or (ii) do not exceed €100 million in total in other cases (including any assets acquired through the use of leverage).

Small Canadian Fund Managers must give written notification to the FCA before marketing in the UK an AIF it manages.  The notification must include a statement confirming that (i) the Fund Manager is the person responsible for complying with the implementing provisions relating to the marketing of the AIF; and (ii) the Fund Manager is a small Canadian Fund Manager.

Furthermore, the small Canadian Fund Manager must provide the FCA with such information as the FCA directs on the main instruments in which the Canadian Fund Manager trades and the principal exposures and most important concentrations of the AIFs that it manages.

UK Transitional Requirements

The UK Regulations grant a one year transitional period from July 22, 2013, which applies to Canadian Fund Managers that have managed an AIF immediately before July 22, 2013 and marketed that AIF in an EEA state before that date. 

Non-binding Policy Statement PS13-05 issued by the FCA in June 2013 notes that “marketing” has a specific meaning within the context of the UK Regulations.  The terms “offering” and “placement” are not defined in the UK Regulations; however, PS13-05 indicates that that an offering or placement will take place for the purposes of the UK Regulations when a person seeks to raise capital by making a unit or share of an AIF available for purchase by a potential investor and includes situations which constitute an invitation to the investor to make an offer to subscribe for the investment (i.e. an “invitation to treat”). 

The FCA has advised that Canadian Fund Managers benefitting from the transitional provisions that wish to continue to market AIFs into the UK under the UK’s private placement regime after the end of the transitional period on July 22, 2014 should submit an application to be registered no later than April 22, 2014.

Transparency Requirements

The UK Regulations stipulate that annual reports be made available by a Fund Manager for each EU AIF it manages (if any) and each non-EU AIF that is marketed in the EU within six months following the end of the financial year. On request, the annual report must also be provided to the AIF’s investors.

The principal items that the annual report must disclose include:

  • balance sheet or statement of assets and liabilities and income and expenditure report;
  • a narrative overview of results/report on activities on the financial year;
  • any material changes in the information disclosed to investors under the UK Regulations during the financial year in question;
  • the total remuneration paid by the Fund Manager to its staff members, the number of beneficiaries and, where relevant, the carried interest paid by the AIF;
  • the aggregate amount of remuneration broken down by senior management and members of staff whose actions have a material impact on the risk profile of the AIF.

Annual reports for non-EU AIFs must be prepared in accordance with the accounting standards of the third country where the AIF has its registered office. Generally speaking, the accounting information given in the annual report for non-EU AIFs must also be audited in accordance with international auditing standards in force in the country where the AIF has its registered office.

Disclosure to Investors

For each non-EU AIF managed by a Canadian Fund Manager and marketed into the EU, the Canadian Fund Manager must make certain information available to investors prior to investment. This information includes a description of:

  • the investment strategy and objectives of the AIF, and the types of assets in which the AIF may invest, the techniques it may employ, all associated risks and investment restrictions and details in relation to any leverage and collateral and asset re-use arrangements;
  • a description of the procedures by which the AIF may change its investment strategy or investment policy;
  • the main legal implications of the investment contract;
  • the identity of the Fund Manager, the AIF’s depositary, auditor and any other service providers, along with a description of their duties and the investors’ rights in relation thereto;
  • a description of how the Fund Manager complies with the requirements to cover professional liability risks under the capital requirement provisions;
  • any delegated management or depositary function and any associated conflicts of interest;
  • the AIF’s valuation procedure and pricing methodology;
  • the AIF’s liquidity risk management, including redemption rights;
  • all fees, charges and expenses (including maximum amounts) borne by investors;
  • any preferential treatment received by an investor;
  • the latest annual report (as described above);
  • the procedure and conditions of issue and sale of units or shares;
  • the latest net asset value of the AIF or the latest market price of the units or shares of the AIF according to the valuation provisions;
  • historical performance of the AIF;
  • prime brokerage arrangements;
  • any arrangements made by the depositary to contractually discharge itself of its liability under the Directive, together with any changes with respect to depositary liability; and
  • how and when periodic disclosures (described further below) will be made.

All information contained in a prospectus of an AIF will be deemed to have been disclosed.

On-going Disclosure

Each Canadian Fund Manager must periodically disclose the following information to investors:

  • the percentage of assets which are subject to special arrangements arising from their illiquid nature;
  • any new arrangements for managing the liquidity of the AIF;
  • the current risk profile of the AIF and a description of the risk management systems employed by the Fund Manager to manage market risk, liquidity risk, counterparty risk and other risks, including operational risk; and
  • where a Canadian Fund Manager manages or markets in the EU an AIF employing leverage on a systemic basis, it shall disclose on a regular basis any changes to the maximum level of leverage permitted (including any right of re-use of collateral or any guarantee granted under the leveraging arrangement) and the total amount of leverage employed by the AIF.

Reporting to Regulators

Separate from the required disclosure to investors, the UK Regulations require a Canadian Fund Manager to provide the regulator in each EU member state in which the AIF is marketed with a significant amount of information as outlined below. Information provided to one EU member state may be accessible by other EU member states under information exchange mechanisms. In particular, information about leverage (described below) will be made widely available from one regulator to the next.

Information to be reported for all AIFs

A Canadian Fund Manager must provide EU member state regulators with information on:

  • the principal markets and instruments in which it trades; and
  • the principal exposures and concentrations of each EU AIF that it manages and each managed non-EU AIF that is marketed in the EU.

On request, a Canadian Fund Manager must also provide a quarterly list of all AIFs that it manages.

Information to be reported for All EU AIFs and All Non-EU AIFs Marketed in the EU

A Canadian Fund Manager must provide EU member state regulators with the following information for each AIF marketed in any EU member state:

  • the percentage of the AIF’s assets subject to special arrangements arising from their illiquid nature;
  • any new arrangements for managing the liquidity of the AIF;
  • the risk profile of the AIF and the risk management systems employed;
  • a description of the risk management systems employed by a Fund Manager to manage market risk, liquidity risk, counterparty risk and other risks, including operational risks;
  • the main categories of assets in which the AIF is invested; and
  • the results of stress tests, if any.

Information to Be Reported for AIFs that Use Leverage “on a Substantial Basis”

An AIF is considered to use leverage “on a substantial basis” when its exposure, as calculated according to the commitment method, exceeds three times its net asset value. The test incorporates both actual leverage represented by bank or margin borrowing and implicit leverage in derivative or trading techniques. Fund Managers managing AIFs that employ leverage on a substantial basis are required to make the following information available to regulators in each EU member state where the AIFs are marketed:

  • the overall level of leverage employed by each AIF it manages;
  • a breakdown between leverage generated through borrowing and the use of derivatives respectively;
  • details of re-use (hypothecation) of assets under leveraging arrangements; and
  • the identity of the five largest sources from which cash or securities are borrowed together with the amounts borrowed.

EU member states are specifically given the right to ask for additional information about leverage.

Portfolio Company Disclosure

The UK Regulations require notifications and disclosures by a Canadian Fund Manager managing an AIF that acquires certain holdings/control of portfolio companies that have their registered office in the EU. The definition of “control” and associated disclosure requirements vary according to whether an acquisition of certain holdings or control relates to a listed or unlisted company.

Definition of Control

In the context of the acquisition of an unlisted company, “control” is generally held to occur when an AIF holds more than 50% of the voting rights of an unlisted portfolio company.

Where a listed company is acquired, “control” is defined with reference to the Takeover Directive, which provides that the percentage of voting rights to give control is determined by the rules of the member state in which the listed company has its registered office. In many member states (including the UK) this is set at 30% although it varies in some other member states.

Notification of the Acquisition of Holdings and Control of Unlisted Companies

A Canadian Fund Manager must notify the competent authority of the voting rights in the unlisted company held by the AIF it manages when the AIF acquires or disposes of shares of an EU-domiciled unlisted company at the following trigger points: 10%, 20%, 30%, 50% and 75%.

A Canadian Fund Manager is also required to provide the following information to the unlisted company, its shareholders and the competent authorities within 10 working days of acquiring control of an unlisted company:

  • the resulting situation in terms of voting rights;
  • the conditions under which control has been reached, including information about the identity of the different shareholders involved, any natural person or legal entity entitled to exercise voting rights on their behalf, (and the chain of undertakings through which voting rights are effectively held); and
  • the date on which the threshold was reached or exceeded.

In its notification, the Canadian Fund Manager must request that the board of directors inform the employee representatives (or where none, the employees) of the acquisition of control and the aforementioned information and use its best efforts to ensure the directors inform the employee representatives or employees, as applicable.

Disclosure on acquisition of Control of Unlisted or Listed Companies

On an acquisition of control of an unlisted or listed company, the Canadian Fund Manager must notify the company, the shareholders, and the competent authorities of:

  • the identity of the Fund Manager(s) which manage the AIF(s) that have acquired control;
  • the policy for preventing and managing conflicts, in particular between the Fund Manager, the AIF and the unlisted company;
  • its policy on external and internal communication relating to the company and, in particular, its employees; and
  • for acquisitions of unlisted companies – its intentions regarding the future business of the unlisted company and the likely repercussions on employment (this information does not need to be provided to the competent authorities).

As before, in its notification, the Canadian Fund Manager must request that the board of directors inform the employee representatives (or where none, the employees) of the acquisition of control and the aforementioned information and use its best efforts to ensure the directors do inform the employee representatives or employees, as applicable.

Financing Information

The Canadian Fund Manager must also disclose to the competent authorities and the AIF’s investors information on the financing of the acquisition when it acquires control of an unlisted company. The UK Regulations do not, however, define “financing” or specify which type of information relating to financing must be disclosed.

Additional Information to be Included in Annual Reports

Where unlisted portfolio companies are controlled by AIFs managed by a Canadian Fund Manager, the Canadian Fund Manager managing the AIF must:

  • either request and use its best efforts to make sure that the annual report of the unlisted company includes the additional information set out below and the board of the company provides it to all employee representatives (or, where there are no employee representatives, directly to the employees) within the period permitted by the applicable national law for drawing up/filing such annual reports; or
  • for each AIF, include in the annual report (described above) the additional information relating to the relevant unlisted company set out below:
    • a fair review of the development of the company’s business outlining the status of the business at the end of the period covered by the annual report;
    • any important events that have occurred since the end of the financial year;
    • the company’s likely future development; and
    • the information on acquisitions of own shares in accordance with the Second Company Law Directive, which requires information on:
      • the reasons for acquisitions made during the financial year;
      • the number and nominal value or, in the absence of a nominal value, the accountable par of the shares acquired and disposed of during the financial year and the proportion of the subscribed capital which they represent;
      • in the case of acquisition or disposal for value, the consideration for the shares; and
      • the number and nominal value or, in the absence of a nominal value, the accountable par of all the shares acquired and held by the company and the proportion of the subscribed capital which they represent.

Exemptions

Notification or disclosure is not required for the types of unlisted companies listed below:

  • special purchase vehicles used to purchase or administer real estate; or
  • small and medium-sized portfolio companies (SMEs), defined as those companies that employ fewer than 250 people in the EU and either:
    • have an annual net turnover not exceeding €50 million; or
    • have a balance sheet total not exceeding €43 million.

Asset Stripping

The UK Regulations restrict distributions (including dividends and interest on shares), capital reductions, share redemptions or purchases of own shares by “controlled” portfolio companies during the first two years of ownership by an AIF.

Asset stripping provisions apply to both listed and unlisted portfolio companies. Under the UK Regulations’ restrictions, the Fund Manager may not “facilitate, support or instruct”, nor vote in favour of, any of the actions mentioned above and must use its “best efforts” to prevent them.

These “asset stripping” restrictions are only applicable to portfolio companies whose registered office is in the EU. The restrictions do not apply to special purpose real estate companies or to SMEs. 

Not all payments to shareholders during the two year period are prevented by these restrictions, however generally speaking only “distributable profits” are allowed to be paid and then only provided the company’s net assets would remain at or above the level of the subscribed capital plus undistributable reserves.

OSC publishes Fund Facts FAQ

The OSC yesterday released a set of frequently asked questions, and associated responses, to assist issuers in using Fund Facts to satisfy the requirements to deliver a prospectus. As we discussed last month, amendments allowing for delivery of Fund Facts, which represent Stage 2 of the CSA's point of sale disclosure framework, came into force on September 1 and will be phased in over the next few years. The FAQ covers issues such as filing of amended Funds Facts, reliance on delivery of Fund Facts prior to the final implementation date of June 13, 2014 and reliance on prior relief granted from prospectus delivery requirements for pre-authorized purchase plans. For more information, see OSC Staff Notice 81-721.

Further thoughts on CSA's proposed operational requirements for "closed-end funds"

Darin Renton and Nick Badeen -

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.

Investment Restrictions

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:

  1. imposing a 10% a concentration restriction (except for fixed portfolio exchange-traded funds (ETFs));
     
  2. limiting investments in physical commodities and specified derivatives with underlying interests in physical commodities;
     
  3. limiting borrowing activities to cash borrowing of up to 30 % of NAV (and permitting borrowing only from “Canadian financial institutions”);
     
  4. limiting investments in mortgages to guaranteed mortgages only;
     
  5. prohibiting non-redeemable investment funds from investing in other non-redeemable investment funds (fund-of-funds);
     
  6. imposing a restriction on investment in illiquid assets (threshold to be determined); and
     
  7. imposing a framework for securities lending, repurchases and reverse repurchases similar to that applicable to mutual funds.

Organizational Costs

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.  

Fundamental Changes

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.

Incentive Fees

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.

Fund facts amendments receive Ministerial approval

Amendments to NI 81-101 Mutual Fund Prospectus Disclosure to allow for the delivery of Fund Facts to satisfy the requirements to deliver a prospectus within two days of buying a mutual fund have now received Ministerial approval in Ontario. As we've previously discussed, this represents Stage 2 of the CSA's point of sale disclosure framework. The amendments will be phased in beginning on September 1, 2013 and will be fully implemented on June 13, 2014.

Canadian regulators sign MOUs with European Regulators under AIFMD

Alix d'Anglejan-Chatillon -

Following our recent post, the Ontario Securities Commission, the Autorité des marchés financiers, the Alberta Securities Commission and British Columbia Securities Commission announced earlier today that they have entered into supervisory Memoranda of Understanding (MOUs) with financial regulators of a number of European Union (EU) and European Economic Area (EEA) member states for the supervision of alternative investment fund managers as required under the EU Alternative Investment Fund Managers Directive (AIFMD).  The AIFMD entered into force on July 22.

The AIFMD will directly impact both Canadian managers which manage funds in the EU and Canadian funds marketed in the EU by Canadian or EU-based fund managers.  Significantly, the AIFM Directive effectively regulates a much broader array of fund structures than conventional alternative investment funds and covers hedge funds, private equity funds, venture capital funds, real estate funds, commodity funds, investment trusts and other collective investment vehicles.   As a result, managers of funds that are not regulated as “investment funds” under Canadian securities laws may be subject to the application of AIFMD in connection with their European activities.

Under the AIFMD, an MOU with the home country regulator must be in place before a non-EU alternative investment fund manager may manage and market alternative investment funds in an EU jurisdiction and perform fund management activities on behalf of EU managers.  The MOUs provide a framework for mutual assistance in the supervision and oversight participants in the asset management industry, including portfolio managers and investment fund managers.

The four Canadian regulators have entered into MOUs with the EU/EEA member-state financial regulators of Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Liechtenstein, Lithuania, Luxemburg, Malta, the Netherlands, Norway, Poland, Portugal, Romania, Slovak Republic, Spain, Sweden, and the United Kingdom.

In Ontario, the MOU is subject to approval by the Ontario Minister of Finance.

OSC identifies issues with investment funds' marketing materials

The Ontario Securities Commission Investment Funds Branch released a notice today setting out the findings of a targeted continuous disclosure review of advertising and marketing materials of publicly offered investment funds. While the review included conventional mutual funds, closed-end funds, exchange-traded funds, commodity pools and labour sponsored investment funds, the OSC focused to some degree on conventional mutual funds as the advertising with this type of fund is primarily targeted to retail investors.

While the report noted general compliance with disclosure requirements related to sales communications, a number of issues were identified. For example, the OSC noted that some basic requirements like providing the date of first publication for a written sales communication, were frequently not met. Ultimately, the reviews led to, among other things, a commitment by fund managers to review older marketing materials more frequently to ensure they remain in compliance with current requirements, the replacement of misleading performance charts, and the removal of potentially misleading headlines, slogans and statements from materials.

Of particular interest, the report takes note of internet advertising. On that topic, the report encourages fund managers to consider the appropriateness of new media formats where "content limitations prevent the fund manager from providing clear, accurate and balanced messages in the sales communication". Warning language, in Staff's view, must be visible on the same page as the sales communication or within one click, and disclaimers should be easily comprehensible to retail investors on first viewing of the advertisement.

Guidance based on OSC Staff's observations from the reviews was also provided. For more information, see OSC Staff Notice 81-720.

OSC's upcoming priorities include shareholder democracy and access to capital

The Ontario Securities Commission yesterday released its statement of priorities for the fiscal year ending March 31, 2014. The statement follows the OSC's publication of a draft in April, and takes into account stakeholder comments received in response to the draft.

Of note, among the priorities listed for the upcoming year, will be a focus on improving shareholder democracy by facilitating the adoption of majority voting by TSX-listed issuers and publishing a consultation paper on key proxy voting infrastructure issues. The TSX announced in October 2012 that it intends to impose majority voting on all of its listed issuers as of December 31st of this year. The OSC states in its statement that it is supportive of the TSX’s initiative and that numerous commentators encouraged the OSC to continue to review shareholder democracy issues as outlined in 2011 in OSC Staff Notice 54-701. With respect to proxy voting infrastructure, the CSA plan to publish a concept paper this summer to outline and seek feedback on key issues.

Other priorities include a focus on disclosure, mainly through cost disclosure and performance reporting by advisers and dealers, delivery of fund facts in the place of a mutual fund prospectus and developing a summary disclosure document for exchange-traded funds or ETFs.

The OSC will also continue its study of a best interest duty on dealers and advisers and its discussion of mutual fund fees and fees for other investment products. Capital market structure and capital raising will be on the agenda as well, with the aim of completing stakeholder consultations on last year's prospectus exemption consultation paper and looking at options to expand access to capital for Ontario issuers, including an examination of Canada's capital market structure and the impact of the order protection rule, electronic trading and market data fees. Finally, as has been the focus for the last few years, in accordance with its G20 commitments, the OSC will also continue working with other CSA members towards implementation of an OTC derivatives regime, including with respect to clearing and trade reporting.

CSA extend comment period on closed-end funds proposal

The CSA today announced an extension to the comment period regarding their proposed changes to NI 81-102 Mutual Funds that would introduce core operational requirements for publicly offered non-redeemable investment funds generally analogous to the requirements applicable to mutual funds and eventually create an alternative investment fund framework under NI 81-104 Commodity Pools.

The CSA are now accepting comments on their proposals until August 23 and invite stakeholder comments on proposals prioritized in the notice. For more information, see CSA Staff Notice 11-324.

Fund Facts delivery requirements finalized

The Canadian Securities Administrators recently announced the implementation of the second stage of their point of sale disclosure project for mutual funds. Stage 2 of the project consists of amendments to NI 81-101 Mutual Fund Prospectus Disclosure and related instruments and forms.

The amendments, which are intended to allow for the delivery of Fund Facts to satisfy the requirements to deliver a prospectus within two days of buying a mutual fund, were previously published for comment in August 2011 and June 2012. The released changes take into account feedback received in the latest round of consultations. While no changes were made to the delivery requirements related to Fund Facts, various changes were made to the form.

Subject to Ministerial approvals, the amendments will be phased in beginning on September 1, 2013 and will be fully implemented on June 13, 2014.

As part of Stage 3 of the project, the CSA intend to publish proposed requirements requiring point of sale delivery of Fund Facts for conventional mutual funds. The CSA will also consider requiring a similar document for other types of publicly offered investment funds.

Latest issue of Investment Funds Practitioner addresses mortgage investment entities and certain prospectus and website disclosure

Darin Renton -

The Investment Funds Branch of the Ontario Securities Commission recently released its latest issue of the Investment Fund Practitioner, dated May 2013. The publication provides an overview of issues identified by the Branch arising from prospectus filings, exemptive relief applications and continuous disclosure documents filed by investment funds.

Of particular interest, Branch staff are looking at whether an issuer investing in non-guaranteed mortgages is, in substance, a corporate issuer rather than an investment fund. In response to an increase in the number of non-redeemable investment funds investing all or most of their assets in pools of non-guaranteed mortgages (also referred to as mortgage investment corporations or MICs), staff have begun to examine the substance of such transactions. According to the Practitioner, any degree of control or active involvement by the mortgage originator or service provider in the formation or operation of the non-redeemable investment fund or portfolio of the fund will cause staff to question whether the issuer is an investment fund. While further guidance on the issue is expected, the Branch recommends that counsel contact staff at an early stage of planning in these types of situations.

The Practitioner includes two notes on best practices for prospectus disclosure—there is one “do” and one “don’t”.

Do: Specifically, the Practitioner outlines Branch staff’s expectation that, in addition to the form requirements, filers that use a short form prospectus are expected to include a "Fees and Expenses" section that describes, among other things, the (i) expenses of the offering; (ii) the subscription fee; (iii) management fees; (iv) operating expenses; and (v) fees payable by securityholders of the fund.

Don’t: Branch staff’s position is that disclaimers of liability for third party information should not be included in a prospectus. Many prospectuses include disclaimers indicating that the issuer is not responsible for information provided by third parties (such as, for example, economic data). Since securities law makes issuers liable for any misrepresentation in a prospectus, including those originating with a reliable third party, in Branch staff’s view, issuers are unable to waive liability for such third party information and such disclaimers should not be included.

Branch staff also remind issuers that Fund Facts documents and IRC Reports to securityholders must be prominently displayed on the website of the fund, fund family or manager.

Beyond the issues discussed above, the Practitioner also considers such topics as scholarship plans making limited investments of the income portion of the plans in equity securities, character conversion transactions, past performance disclosure in flow-through limited partnership prospectuses and margin deposit exemptive relief for commodity pools.

OSC asks investment fund managers to consider budget changes to forward agreements

The Ontario Securities Commission yesterday released a staff notice setting out the issues that investment fund managers should consider in light of the recent federal budget. Specifically, under proposed amendments to the Income Tax Act, distributions to unitholders of a mutual fund resulting from partial or full settlements of a forward agreement will now be treated as income distributions.

According to OSC Staff, investment fund managers should consider the effects of these changes on their funds, especially if the income conversion feature is an "essential" aspect of the fund, and specifically with respect to compliance with their disclosure obligations and the need for communication with current securityholders. The notice also suggests that managers consider on a longer-term basis whether to cap affected funds to new and additional investments, whether changes to funds' investment objectives and strategies will be needed, and whether funds need to be restructured, reorganized or terminated.

For more information, see OSC Staff Notice 81-719.

CSA propose operational requirements for closed-end funds

Joel Binder -

The Canadian Securities Administrators yesterday proposed changes to National Instrument 81-102 Mutual Funds (NI 81-102) that would introduce core operational requirements for publicly offered non-redeemable investment funds generally analogous to the requirements applicable to mutual funds.

This "Phase 2" of the CSA's Modernization of Investment Fund Product Regulation Project involves significant changes to the regulation of non-redeemable investment funds. Key elements of the proposals include (i) extending the application of investment restrictions under NI 81-102 to non-redeemable investment funds; (ii) imposing a 10% concentration restriction (with fixed portfolio ETFs permitted to exceed this limit); (iii) limiting investments in physical commodities and specified derivatives with underlying interests in physical commodities; (iv) imposing a cash borrowing limit of up to 30% of NAV (and permitting borrowing only from "Canadian financial institutions" and limiting borrowing activities to cash borrowing only); and (v)limiting investments in mortgages to guaranteed mortgages only. In addition, dilutive securities issuances would be prohibited with specific prohibitions on the ability to issue warrants or similar securities.  

Non-redeemable investment funds would also be prohibited from investing in other non-redeemable investment funds (fund-of-funds) while a larger portion of fund assets would be permitted to be invested in illiquid assets. The proposals would also impose a framework for securities lending, repurchases and reverse repurchases similar to that applicable to mutual funds and introduce new requirements for the manager to bear the organizational costs of launching a new fund, as well as prescribe requirements governing conflicts of interest and circumstances where regulatory and/or securityholder approval will be required for certain fund or management changes. Changes are also proposed to requirements for custodianship of assets, redemptions and prescribed prospectus disclosure.

While the proposals relate principally to non-redeemable investment funds, some of the proposed amendments would also impact mutual funds.

The proposals form part of Phase 2 of the CSA's investment fund modernization project. Phase 1 of the project, which codified exemptive relief frequently granted in recognition of market and product developments, came into force in 2012. The purpose of Phase 2 is to "identify and address any market efficiency, investor protection or fairness issues" arising as a result of the different regulatory regimes that apply to different types of funds.

Included in Phase 2 is the creation of a more comprehensive 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 alternative investment strategies not be permitted under NI 81-102. While specific amendments to NI 81-104 are not proposed at this time, the CSA have raised a number of questions on which feedback is requested.

The CSA is accepting comments on their proposals until June 25, 2013.

Ontario CM participation fee due April 1 for UIFMs with December 31 year end

A reminder to unregistered investment fund managers (UIFMs) that the annual capital markets participation fee (CM participation fee) applicable only in Ontario is due within 90 days of a UIFM’s year end. For UIFMs with a December 31 year end, the due date is Monday, April 1, 2013. Late fees apply and accrue.

The amount of the CM participation fee is determined on a sliding scale based on the amount of the UIFM's "specified Ontario revenues" for its previous financial year attributable to capital markets activities in Ontario. UIFMs must complete and deliver to the OSC (along with the fee payment) a Form 13-502F4 Capital Markets Participation Fee Calculation setting out the basis on which the CM participation fee paid by the UIFM was computed.

OSC amendments to fee rules approved

The Ontario Securities Commission announced today the approval of amendments to OSC Rule 13-502 Fees and OSC Rule 13-503 (Commodity Futures Act) Fees.  The amendments come into effect on April 1, 2013.

OSC releases overview of issues impacting investment funds

The Ontario Securities Commission yesterday released a report that provides an overview of the key initiatives undertaken by the regulator during 2012 that impact investment fund issuers. Such projects concern: (i) modernizing investment fund product regulation, (ii) point of sale, (iii) scholarship plans and (iv) mutual fund fees.

Emerging issues and trends are also considered, including prepaid forward structures in prospectus offerings, investment funds with exposure to physical commodities and the increase in linked note offerings.

The report also considered OSC Staff's findings and concerns resulting from a targeted review of the continuous disclosure filings of Ontario-based investment funds. Identified issues included concerns with advertising and marketing materials (observations and guidance on this subject are expected this Spring), as well as with respect to risk ratings in fund facts (which in some cases resulted in mutual fund managers changing the risk rating of the fund). For more information, see OSC Staff Notice 81-718.

OSC publishes final amendments to fee rule

Last month, the Ontario Securities Commission published final amendments to OSC Rule 13-502 Fees and its companion policy that will see an increase to the current fees payable by market participants. As we described in August 2012, the OSC published proposed amendments to its fee structure last year.

While the final version of the amendments is generally consistent with the earlier proposal, the OSC has taken steps to address some of the concerns communicated during the public comment process. For example, while the original proposals contained increases in participation fees over a three-year fee cycle of 7.9% per year for registrants and 15.5% for issuers, the increases have been reduced to 4.7% and 11.65% per year, respectively.

Of note, the OSC has exempted unregistered investment fund managers that do not have a place of business in Ontario from the requirement to calculate and pay capital market participation fees where the investment fund manager does not have security holders resident in Ontario or where there has been no active solicitation of investors in Ontario after September 27, 2012. However, while many commentators expressed opposition to the OSC’s proposed change to the calculation of fees based on a “reference fiscal year”, which for many market participants will result in the fees payable over the next three years to be based on historical market capitalization or revenue data rather than current data, the OSC, citing the need for predictability in its fee revenues, proceeded with this change.

Assuming Ministerial approval, the amendments to both rules will come into force on April 1, 2013.

CSA initiate consultation on mutual fund fee structure

The Canadian Securities Administrators yesterday released a discussion paper intended to solicit feedback on the structure of mutual fund fees in Canada. In addition to providing an overview of the current mutual fund fee structure, the paper identifies investor protection and fairness issues resulting from the current structure, and also considers the potential regulatory options available to the CSA to address the identified issues.

Specifically, the paper considers such issues as the lack of investor understanding of fund costs, potential conflicts of interest at the mutual fund manufacturer and advisor levels, the potential for cross-subsidization of commission costs, alignment of advisor compensation and services, and the potential for low-cost options for do-it-yourself investors.

In response to the identified issues, the CSA state that they may consider a number of potential regulatory changes, including: (i) establishing a minimum level of ongoing services that advisors would have to provide investors in exchange for payment of trailing commissions; (ii) requiring a standard class for DIY investors with no or reduced trailing commissions; (iii) requiring that the trailing commission component of a mutual fund's management fee be unbundled and charged and disclosed as a separate fee; (iv) setting a maximum limit on the portion of mutual fund assets that could be used to pay trailing commissions to advisors; and (v) implementing additional standards or duties for advisors.

Also of note, the impact of any potential regulatory changes could affect stakeholders outside the mutual fund industry. Specifically, the CSA state that while the paper focuses on mutual funds, the regulatory changes may also eventually capture investment funds and comparable securities products. 

The CSA are accepting feedback on the consultation paper until April 12, 2013. For more information, see CSA Discussion Paper 81-407.

OSC seeks improvement in disclosure of investment funds' portfolio holdings

Last week, the Ontario Securities Commission released a notice reporting on staff's continuous disclosure review of investment funds' portfolio holdings. Ultimately, the report found that funds' continuous disclosure could be improved in order to provide "more meaningful information" regarding portfolio composition and how a fund's investments align with the investment objectives set out in the fund's prospectus.

Specifically, the report noted a few key trends: (i) the use of portfolio categories that did not reflect the unique characteristics of the fund as set out in its investment objectives; (ii) inconsistencies in the categories used across different disclosure documents of the fund to describe the investments in the portfolio; and (iii) the use of broad, generic categories rather than more specific categories that would provide more meaningful information on portfolio composition and the alignment with investment objectives.

Ultimately, OSC Staff issued comments on 120 of the 203 funds reviewed. While none of the funds were required to refile disclosure documents, OSC staff indicated that they expect improved disclosure in the future. Specifically, the notice states that of the fund managers receiving comment letters, 33% have committed to improving the portfolio listing in their financial statements, 36% will improve portfolio categorization in their Management Reports of Fund Performance and 26% will improve the categorization of the investment mix in their Fund Facts.

The notice also encourages investment fund managers to consider the guidance provided in the notice in preparing continuous disclosure. For more information, see OSC Staff Notice 81-717.

Regulators adopt registration exemptions for non-resident IFMs

Martine Ordon -

The CSA yesterday announced the adoption of new instruments and policies to address the registration of non-resident investment fund managers, as well as the issuance of parallel orders to extend the transition provisions regarding the registration requirement of IFMs from September 28 to December 31, 2012.

Specifically, the OSC, Quebec's Autorité des marchés financiers and Newfoundland and Labrador's Financial Services Regulation Division, Service NL announced the implementation of Multilateral Instrument 32-102 Registration Exemptions for Non-Resident Investment Fund Managers, which provides an exemption from the investment fund manager registration requirement where an IFM does not have a place of business in the local jurisdiction and if either (i) none of the investment funds has security holders resident in the local jurisdiction; or (ii) the IFM and those investment funds have not, at any time after September 27, 2012, actively solicited residents in the local jurisdiction to purchase securities of the fund.

Meanwhile, all other jurisdictions in Canada released Multilateral Policy 31-202 Registration Requirements for Investment Fund Managers, which is intended to provide guidance with regards to determining whether registration as an IFM is required in those jurisdictions. As we noted in an earlier post describing the initial proposal, these jurisdictions would allow the applicable exemptions found in NI 31-103 to expire, but would subsequently interpret the registration requirements to only require registration as an investment fund manager in a jurisdiction if the investment fund manager directs or manages the business, operations or affairs of an investment fund in that jurisdiction.

The MP 31-202 jurisdictions noted that many of the comments received in response to an earlier version of MP 31-202 agreed that a registration trigger based on the functions and activities of investment fund managers was preferable to one based on the presence of security holders or solicitation of investors. Notably, New Brunswick, which had previously been a party to MI 32-102 along with Ontario, Quebec and Newfoundland and Labrador, has now switched sides to join the majority of the jurisdictions.

As we described our February post, both camps proposed earlier versions of their multilateral instruments/policies earlier this year. Assuming ministerial approvals, the new and amended instruments and policies will now come into effect on September 28, 2012.

The CSA also announced that they are reviewing the dispute resolution provisions in NI 31-103 and may publish proposed amendments in the future. In the meantime, the CSA are extending the exemption from the requirement to provide dispute resolution services until the earlier of September 28, 2014 or the coming into effect of amendments to the dispute resolution provisions.

CSA update proposals regarding Fund Facts delivery

The CSA today published for a second time proposed amendments to NI 81-101 Mutual Fund Prospectus Disclosure regarding the delivery of Fund Facts following the purchase of a mutual fund. As we discussed last year, the CSA initially released their Stage 2 proposals in August 2011, and the current version of the amendments are intended to address stakeholder feedback.

Stage 2 of the point of sale disclosure framework is intended to allow the delivery of Fund Facts to satisfy the requirements under securities legislation to deliver a prospectus within two days of buying a mutual fund. The changes published today focus primarily on the requirements regarding the presentation of risk in the Fund Facts document.

Comments on the proposed amendments are being accepted until September 6, 2012.

OSC releases April 2012 issue of Investment Funds Practitioner

Darin Renton -

The Investment Funds Branch of the Ontario Securities Commission recently published the April 2012 issue of its Investment Funds Practitioner. The publication provides an overview of issues identified by the Branch arising from exemptive relief applications, prospectus filings and continuous disclosure documents filed by investment funds with the OSC.

Prospectus Issues

The Practioner highlights a number of issues that have come to light in the course of prospectus reviews, including amending a final prospectus to fix incorrect fee disclosure, and fund names that are inconsistent with the fund's investment objectives or strategies. On the latter issue, Branch Staff state that fund managers should select names that "closely reflect the fund's investment objectives" and that distinguish the funds from others. Branch Staff will consider whether additional guidance or rule-making is needed on this point.

Staff have also considered the issue of ETFs that track indices that are not widely used or recognized. According to the Practitioner, a fund's disclosure respecting investment objectives cannot be limited to a statement that the fund aims to replicate the performance of a specific index. Additional information is required, including with respect to primary asset composition and key features of the fund under normal market conditions. Staff have also started reviewing portfolio transparency of actively-managed ETFs in continuous distribution and advise that they expect any separate fees that are paid to a counterparty under a forward agreement (intended to compensate for the cost of hedging its exposure) to be disclosed in the prospectus of the fund.

Also discussed is Branch Staff's concern with closed-end funds that propose to invest either directly or through a derivative such as a forward agreement, in foreign-based investment funds or portfolios that are not reporting issuers in Canada. According to the Practitioner, Branch Staff will generally ask for certain disclosure concerning each underlying fund in the course of their prospectus review, and may ask that certain disclosure, such as the risk associated with enforcing legal rights against non-residents, be highlighted and put in a textbox on the prospectus cover page. Staff further express their views on how continuous disclosure obligations of the fund may be impacted and advise that they typically will request the underlying fund manager to file a submission of jurisdiction and appointment for service of process.  The Practitioner advises that Staff typically will ask that the financial statements and other continuous disclosure of the underlying fund be filed on the SEDAR profile of the closed-end fund.

Finally, with respect to prospectus offerings, Branch Staff have highlighted their ongoing concerns with standalone warrant offerings by closed-end funds, including the dilutive effective on the value of units, the potential for such offerings to be coercive to existing unitholders and the potential conflict of interest that may exist with respect to the manager of the fund.

Continuous Disclosure Issues

In this area, the Practioner canvasses issues emanating from Branch Staff's recent review of select investment funds that make regular distributions to investors. A number of issues emanating from the review were identified, including the practice of paying distributions that are regularly and significantly in excess of the fund's increase in NAV from operations. According to Branch Staff, whereas terms such as "yield" or "income" imply earnings, such distributions are, in substance, a return to investors of capital.

Further, Branch Staff state that funds that pay distributions in the form of reinvested units as a default conflicts with a fund's stated focus of providing investors with regular income, as the onus falls on the investor to select distributions in cash. The Practioner thus outlines a number of disclosure related obligations required of such funds. Further guidance or rule-making may be released.

The Practitioner also discusses Branch Staff's recent reviews of portfolio disclosure (observations and guidance arising out of the review are expected by this summer) and Fund Facts risks. On the latter issue, Branch Staff remind filers that they will generally consider changes to a mutual fund's risk level to be a material change under securities legislation.

Staff of the Investment Funds Branch are accepting feedback on the Practioner and suggestions for future topics to be reviewed.

IFRS for investment funds deferred until January 1, 2014

The Canadian Securities Administrators (CSA) today released an updated version of Staff Notice 81-320 regarding the adoption of IFRS by investment funds in Canada. The notice was first published in October 2010, and revised in March 2011. Ultimately, the revisions to the notice reflect the fact that the Accounting Standards Board has extended the mandatory changeover date to IFRS for investment funds to January 1, 2014. According to the AcSB, the deferral reflects the likelihood that the IASB will not issue proposed guidance on investment entities before January 1, 2013.

IIROC announces implementation of core elements of CRM project

Yesterday, the Investment Industry Regulatory Organization of Canada (IIROC) announced the approval of amendments to Dealer Member Rules to adopt core elements of its Client Relationship Model (CRM) Project for investment dealers. Specifically, the amendments provide for(i) improved relationship disclosure, including requiring that investors receive more information on account types and transaction and account fees; (ii) enhanced standards regarding conflicts of interest management and disclosure; (iii) increased suitability assessment standards to ensure that investments are appropriate to investors' objectives and time horizon; and (iv) account performance reporting.

While most of the amendments will come into force over the next two years, the account performance reporting requirements have been deferred until the CSA performance reporting requirement have been finalized. The amendments were last published for comment in January 2011. The approved amendments reflect revisions made to address comments received.

Meanwhile, IIROC also published guidance to assist dealers on compliance with the new requirements, as well as guidance relating to "know your client" and suitability obligations. For more information, see IIROC Notices 12-0107, 12-0108 and 12-0109.

New Canadian proposals for non-resident investment fund manager registration

Kathleen Ward, Ken Ottenbreit and Alix d’Anglejan-Chatillon -

As discussed in our post of February 10, the Canadian Securities Administrators (CSA) recently published two sets of proposals relating to the registration of non-resident investment fund managers (IFMs). The provinces of Ontario, Quebec, New Brunswick and Newfoundland and Labrador, referred to here as the “Exemption Jurisdictions” have proposed one approach, while the other six provinces and three territories referred to here as the ”Policy Jurisdictions”, have taken another. The key differences between the two approaches are highlighted below.

The securities regulators in both the Exemption Jurisdictions and the Policy Jurisdictions make it clear that if an IFM is directing or managing the business, operations or affairs of an investment fund from a place of business in a Canadian jurisdiction, the IFM would need to be registered there. The difference in the proposals is the effect of offering securities or having investors in the jurisdiction.

The Exemption Jurisdictions

In their request for comments, the securities regulators of the Exemption Jurisdictions state the view that the distribution of investment fund securities in an Exemption Jurisdiction is a significant connecting factor to the jurisdiction and the investment fund registration requirement is triggered by a non-resident IFM if either the investment fund or the IFM distributes or has in the past distributed investment fund securities in the jurisdiction. They are proposing a new rule with two exceptions to the registration requirement.

The “no security holders or active solicitation” exception

First, securities regulators of the Exemption Jurisdictions are proposing that the IFM registration requirement would not apply to a person or company acting as an IFM of an investment fund that does not have a place of business in the Exemption Jurisdiction and if one or both of the following apply:

  1. the investment fund has no security holders resident in the Exemption Jurisdiction;
  2. the investment fund or the IFM has not actively solicited residents in the Exemption Jurisdiction to purchase securities of the investment fund.

The “permitted client exception”

Second, securities regulators of the Exemption Jurisdictions are proposing an exception to the registration requirement for non-resident IFMs where the investment fund’s securities distributed in the Exemption Jurisdiction are distributed on a prospectus exempt basis to “permitted clients” only. Certain other conditions, most of which are similar to those applicable under the international adviser or international dealer exemption, must also be met to rely on this exception (including the appointment of an agent for service, the filing of a notice of submission to jurisdiction, prior notice to permitted clients, etc.).

However, there are two additional filing or information requirements applicable to the permitted client exception. First, the non-resident IFM would have to report to the local securities regulator by December 1 of each year the total assets under management attributable to securities beneficially owned by residents of the Exemption Jurisdiction. Second, the non-resident IFM would be required to file with the local securities regulator a Notice of Regulatory Action (on Form 32-102F2) within 10 days of the date that it begins to rely on the permitted client exception. Notice of any change to such Form would be required to be reported within 10 days of the change. This is a potentially onerous filing and ongoing reporting obligation that is not required under either the international adviser or international dealer exemption.

The proposed rule in the Exemption Jurisdictions does not exempt non-resident IFMs of investment funds from registration where the securities were placed in the local jurisdiction in the past only. The lack of a “grandfathering” provision is potentially very significant for investment funds which are no longer offering securities in Canada but have existing investors in any Exemption Jurisdiction.

The Policy Jurisdictions

The securities regulators in the Policy Jurisdictions are proposing to adopt a policy to the effect that merely having investors resident in the Policy Jurisdiction and solicitation of investors do not automatically subject the IFM to the registration requirement. Under this proposal, an IFM would only be required to register in the Policy Jurisdiction if it directs or manages the business, operations or affairs of the investment fund in that jurisdiction. According to the proposal, consideration should be given to what activities are taking place in these jurisdictions. The Policy Jurisdictions are not proposing to adopt any specific exemptions.

As noted in our earlier post, if IFM registration is required in the Exemption Jurisdictions the deadline to submit an application for registration would be extended to December 31, 2012. In the Policy Jurisdictions, the deadline for application would be September 28, 2012. The securities regulators are accepting comments on the proposals until April 10, 2012.

Reminder: Ontario capital markets participation fees for unregistered IFMs due within 90 days of their year end

A reminder to unregistered investment fund managers (UIFMs) that the annual capital markets participation fee (CM participation fee) applicable only in Ontario is due within 90 days of a UIFM’s year end. For UIFMs with a December 31 year end, the due date is Friday, March 30, 2012. Late fees apply and accrue.

The amount of the CM participation fee is determined on a sliding scale based on the amount of the UIFM's "specified Ontario revenues" for its previous financial year attributable to capital markets activities in Ontario. UIFMs must complete and deliver to the OSC (along with the fee payment) a Form 13-502F4 Capital Markets Participation Fee Calculation setting out the basis on which the CM participation fee paid by the UIFM was computed.

CSA adopt amendments to mutual fund and investment fund regulatory framework

The CSA announced last week that it is adopting amendments to complete the first phase of its project to modernize the product regulation of publicly offered investment funds. The amendments, initially published as a proposal in June 2010, seek to codify exemptive relief frequently granted to address market and product developments over the years in the investment fund industry. According to the CSA, these amendments to NI 81-102 Mutual Funds and related consequential amendments help to modernize the investment fund rules by making requirements "more effective and relevant in today's more diverse and increasingly innovative retail fund marketplace."

Specifically, among other things, the amendments will: (i) eliminate the need for ETFs to seek exemptive relief from certain operational requirements designed primarily for open-end conventional mutual funds; (ii) allow mutual funds to short sell securities subject to a cap of 20% of their net asset value; and (iii) introduce new investment restrictions for money market funds.

The final rules reflect changes made in response to comments to the 2010 proposal. As these changes are not considered material, the amendments will, assuming Ministerial approvals, come into effect on April 30, 2012.

Regulators propose registration exemptions for non-resident IFMs

Regulators from Ontario, Quebec, New Brunswick and Newfoundland and Labrador today published a proposed multilateral instrument that would exempt non-resident investment fund managers from the requirement to register in circumstances where there are no security holders of the investment fund, or active solicitation of residents, in the local jurisdiction. The instrument, which would apply in the participating jurisdictions, would apply to investment fund managers that do not have their head office or principal place of business in a jurisdiction of Canada and that do not have a place of business in the local jurisdiction. An exemption would also exist from the registration requirement in cases of distributions only to permitted clients.

Ultimately, the exemption from registration would extend the current temporary exemptions found in NI 31-103 and require affected investment fund managers to apply for registration by December 31, 2012. The participating regulators are accepting comments on the proposal until April 10, 2012. For more information, see proposed MI 32-102.

Meanwhile, securities regulators in the remaining provinces and territories have published a separate multilateral instrument that would allow the applicable exemptions found in NI 31-103 to expire on September 28, 2012 as planned, but would subsequently interpret the registration requirements to only require any entity to register as an investment fund manager in a jurisdiction if it directs or manages the business, operations or affairs of an investment in that jurisdiction. In determining whether registration is required, the proposed instrument would look at the functions and activities of the entity, and the presence of security holders and the solicitation of investors in a jurisdiction would not automatically require an investment fund manager to register. Affected investment fund managers in these jurisdictions would be required to apply for registration by September 28, 2012. Like the proposed instrument described above, comments are being accepted until April 10, 2012. For more information, see proposed MI 31-202.

In both cases, the proposals are intended to replace the CSA proposal published in October 2010, with which the CSA are not proceeding.

BCSC expands exemptions to new private placement disclosure requirements

Ramandeep Grewal -

The British Columbia Securities Commission has now replaced BC Instrument 45-533, which granted limited relief from its new private placement disclosure form (Form 45-106F6 or the "BC Form") with a new version of the Instrument. As we've discussed in earlier posts, private placements in British Columbia have been subject to expanded post-trade disclosure requirements since October 3rd. The new version of the Instrument expands on the range of circumstances under which an issuer or underwriter can avoid having to file Form 45-106F6. Exemptions from certain parts of the BC Form are also provided.

Specifically, all investment funds (not just those managed by a Canadian registered manager) are now exempt from filing the BC Form (and can instead file a Form 45-106F1 or the "National Form"). Issuers or underwriters distributing securities of a non-reporting issuer only to permitted clients (as defined in NI 31-103) are also exempt from filing the BC Form provided they file the National Form and provide notice of their reliance on the filing exemption. Meanwhile, foreign public issuers and their subsidiaries, as well as subsidiaries of reporting issuers, are now exempt from having to provide information in item 4 of the BC Form (which is the item that requires detailed information about insiders and their holdings). Further, "insider information" under item 4 will now only be required for directors, executive officers, promoters and control persons.

The new Instrument came into force on December 9, 2011.

OSC registrant compliance report flags deficiencies and provides guidance

Alix d'Anglejan-Chatillon and Alex Colangelo

On September 23, the Ontario Securities Commission released OSC Notice 33-736 – 2011 Annual Summary Report for Dealers, Advisers and Investment Fund Managers. While the report was prepared by the OSC’s Compliance and Registrant Regulation Branch (the Branch) to assist dealers, advisers and investment fund managers in complying with Ontario securities laws, it provides useful guidance for registrants and applicants for registration in all Canadian jurisdictions. The report primarily covers the OSC’s 2011 fiscal year and (i) reviews recent developments in light of the new registration regime; (ii) considers Canada’s response to global financial developments, including with respect to OTC derivatives regulation and the potential systemic risks posed by hedge funds; (iii) discusses the OSC’s recent focus on registrant misconduct; (iv) provides information for firms and individuals applying for registration by, among other things, identifying common deficiencies in registration applications and providing corresponding guidance; and (v) identifies trends in deficiencies and suggested practices for registrants, advisers, investment fund managers and dealers based on ongoing compliance reviews.

Common deficiencies from registration applications

Of particular interest for firms and individuals applying for registration is the information regarding deficiencies commonly found in applications for registration. The report notes that the processing of an application for registration may be delayed due to inadequate detail. Accordingly, applicants would be well advised to carefully review the Branch’s findings prior to submitting registration applications.

The report categorizes specific deficiencies by form, including: (i) Form 33-109F6 Firm Registration, where insufficient information may be provided regarding such things as proposed business activities, ownership and bonding and insurance; (ii) Form 33-109F5 Change of Registration Information, where sufficient details of the relevant change are not always provided; (iii) Form 33-109F4 Registration of Individuals and Review of Permitted Individuals, where deficiencies include insufficient evidence of proficiency and incomplete information regarding previous employment and other activities; and (iv) Form 33-109F5 Change of Registration Information, where the report notes that the OSC is often not provided notice when an individual becomes a shareholder of his or her sponsoring firm.

Compliance-related deficiencies

During the course of the year, the OSC also conducted compliance reviews of selected registered firms to assess compliance with Ontario securities laws. The outcomes of the reviews ranged from enhanced compliance, which consists of the OSC issuing a report to a firm identifying areas requiring corrective action (31% of firms reviewed), to enforcement branch referral where serious breaches of securities laws were identified (9% of reviewed firms). Between the extremes were firms requiring significantly enhanced compliance, which involves an enhanced monitoring regime (57% of firms) and the imposition of terms and conditions on registration (3% of firms).

The report also discusses the various deficiencies identified by the compliance reviews and provides guidance in addressing these issues.

All registered firms

Excess working capital

According to the report, some firms are not calculating excess working capital accurately on Form 31-103F1. Specifically, current assets that are not readily convertible into cash, such as prepaid expenses and security deposits with service providers should be excluded from the calculation. The report also expresses concerns with respect to accounts receivables that are not readily convertible to cash, especially those from related parties. According to the report, any receivables that are not convertible to cash in a “prompt and timely manner” should be excluded from the calculation of excess working capital.

Inadequate insurance coverage

The report also cites the fact that some registered portfolio managers and investment fund managers fail to maintain an adequate amount of insurance coverage over their clients’ assets as assets increase during the year. The report therefore recommends that registered firms, in determining an adequate level of insurance coverage, take into account the expected growth in a registrant’s business. Firms should also ensure that a “double aggregate limit” or “full reinstatement of coverage” is provided under their bonding or insurance.

Social media procedures

Although the use of social media by registered firms to market products and services is currently limited, the report also provides suggested practices for firms to consider. Namely, the report recommends (i) setting policies and procedures for the review, supervision, retention and retrieval of materials on social media; (ii) designating an appropriate individual to be responsible for the supervision and approval of communications; and (iii) reviewing the adequacy of systems and programs to ensure compliant record retention and retrieval capability.

CCO report

The report also states that there is often no evidence that a registered firm’s Chief Compliance Officer (CCO) has submitted an annual report to the firm’s board of directors, or equivalent, that assesses compliance by the firm and its registered individuals with securities law. In response, the report suggests that a CCO prepare and maintain a written annual compliance report that is presented to the firm’s board and that describes what steps were taken to perform the compliance assessment, the result of the assessment and what has been done or will be done to address significant instances of non-compliance. In cases where the CCO has presented the compliance report orally, it may be appropriate for the minutes to the board meeting to document the discussion and describe the appropriate information.

Portfolio managers

Cross trades

The report expresses concern with portfolio managers effecting trades between client accounts (cross trades). On this issue, the report reminds portfolio managers of the restrictions on certain managed account transactions and inter-fund trades by public investment funds. A portfolio manager that crosses trades between client accounts (where it is permissible to do so) should: (i) ensure that the executed price for cross trades is fair to both clients; (ii) ensure that the fees charged on cross trades are reasonable; (iii) ensure that cross trades are executed through a dealer; (iv) establish policies and procedures containing guidelines on cross trades; and (v) ensure that the methodology for allocating cross trade opportunities among client accounts is fair and equitable to all clients.

Soft dollar arrangements

On the topic of client brokerage commission disclosure, the report notes that some portfolio managers are not providing the required disclosure to clients regarding soft dollar arrangements. As such, portfolio managers that are required to provide such disclosure should establish policies and procedures containing guidelines on providing adequate disclosure, ensure that the period of time chosen for the periodic disclosure is consistent from period to period, determine the form of disclosure based on client needs and provide the required disclosure in conjunction with other initial and periodic disclosure relating to the performance and management of the account.

Delegation of KYC obligations

The delegation of “know-your-client” (KYC) and suitability obligations also drew the attention of the Branch. Specifically, some portfolio managers enter into arrangements with mutual fund dealing representatives and firms, or financial planners, for the referral of clients to the portfolio manager for a managed account. The Branch thus expressed its concern that portfolio managers are not having meaningful discussions with referred clients to fully understand the clients’ financial circumstances and risk tolerance. Rather, portfolio managers may instead be relying on the mutual fund dealing representative or financial planner to perform these duties and, in some cases, unregistered individuals working for the portfolio manager firm may be performing the required duties.

In response, the report states that an advising representative of the portfolio management firm should have a meaningful discussion with each client regarding KYC information before managing a portfolio, explain the firm’s investment process and strategy and other relationship information to the client, assist the client in completing necessary forms and agreements, regularly communicate the investment holdings and performance, and keep each client’s KYC information up to date.

Investment fund managers

Inappropriate expenses charged to funds

According to the report, some investment fund managers (IFMs) allocate expenses to their investment funds that are unrelated to the operation of the funds. Examples of this practice include expenses related to the operation of the investment fund managers’ business, such as capital market participation fees, expenses relating to social events and expenses relating to the wholesaling activities of the IFM.

As a result of these practices, the report recommends that IFMs establish policies and procedures, as well as a system of controls, to ensure that the IFM’s investment funds are only paying for expenses that are related to the operation of the investment funds. Further, the report suggests expense allocations should be reviewed on a regular basis to ensure that only appropriate expenses are charged and paid for by the investment funds.

IRC assessments

The report also considers the requirement of investment fund managers that are also reporting issuers to have an independent review committee (IRC) to review and assess the adequacy and effectiveness of the investment fund manager’s written policies and procedures. According to the Branch, not all IRCs properly document assessment results. Thus, investment fund managers should ensure that they receive and maintain records of the regular assessments conducted by the IRC and address any matters raised in the IRC’s reports in a timely and appropriate manner.

Investment funds modernization project

The report also provides an update on the investment funds modernization project. Specifically, phase one amendments are expected in final form by the end of 2011 with an effective date in early 2012. With respect to point of sale disclosure, the Canadian Securities Administrators plan to publish for further comment any proposed requirements that would implement point of sale delivery for mutual funds.

Exempt market dealers

KYC and suitability information

The report identifies various issues regarding the collection of KYC information, assessment of suitability and knowledge of products recommended to clients by exempt market dealers (EMDs). The report also sets out a number of suggested practices to address these deficiencies. Specifically, EMDs and their registered individuals should ensure that they: (i) have a process is in place to collect and document sufficient KYC information for each client; (ii) have clients sign-off on completed KYC forms; (iii) have an in-depth understanding of the general features and structure of a product, the product risks (including the risk/return profile and liquidity risks), the management and financial strength of the issuer, costs and any eligibility requirements for each product before recommending the product to clients; (iv) perform an independent analysis of products before recommending them to clients; and (v) perform ongoing due diligence of the issuer and products.

(Non)Accredited investors

The Branch also expressed concern that prospectus-exempt securities are being sold in reliance of the “accredited investor” exemption to investors that do not meet the relevant qualifications. As such, the report states that EMDs should have a process in place to collect and document sufficient KYC information for clients in order to determine whether the applicable definition for “accredited investor” has been met. EMDs should also explain the definition of “accredited investor” to clients before completing the KYC form to ensure that assets are properly characterized and documented.

Supervision of dealing representatives

On the issue of supervision, the report discusses the issue of EMDs not adequately supervising their dealing representatives, especially where representatives are working in locations different than that of their supervisor. As such, the report suggests that EMDs provide ongoing training for dealing representatives to ensure that representatives (i) are aware of the securities laws impacting their activities; (ii) understand their sponsoring firm’s policies and procedures; (iii) have an in-depth understanding of the products they recommend to clients; and (iv) are informed of any changes to the above on a timely basis. According to the report, EMDs should also develop written policies and procedures regarding the supervision of dealing representatives’ activities, including the activities to be supervised and by whom, the frequency of supervision and how the supervision will be evidenced.

Unregistered representatives

In order to respond to the issue of individuals acting on behalf of EMDs who are not registered as a dealing representative, the report suggests that EMDs, among other things, assess whether a change in an individual’s role, responsibilities or activities within the firm requires registration and assess whether changes to the firm’s business activities require registration in another category.

Inappropriate marketing practices

The marketing practices of EMDs is identified by the report as a particular area of concern, with “many” EMDs cited as providing outdated or misleading information to clients. According to the report, marketing materials should: (i) provide clear and adequate disclosure to ensure that the information is “complete, accurate and meaningful”; (ii) substantiate all claims made, with reference to information supporting the claim so that investors can easily assess the merits of the claim; (iii) be updated regularly to ensure all information is complete, accurate and current; and (iv) provide prominent, specific and clear disclosure to clients that explains any conflict of interest and how it could affect the client.

On-site compliance reviews

Using a risk assessment questionnaire sent to all Ontario registered EMDs in October 2009, the Branch identified a number of EMDs for on-site compliance reviews. The reviews, conducted in December 2010 focused on key risk areas and found a number of further deficiencies, including with respect to the inappropriate use of investor monies, non-disclosure of outside business activities and inadequate working capital and insurance coverage. The report provides a number of suggested practices to deal with these additional deficiencies.

OSC releases investment fund issuers report

The OSC released a report today providing an overview of initiatives impacting investment fund issuers. Specifically, the report reviews the status of the OSC's key policy initiatives, including the CSA's project to modernize investment fund product regulation, the Point of Sale disclosure project, and proposed amendments to prospectus requirements.

The report also discusses observations and findings emanating from OSC Staff's prospectus reviews of non-redeemable investment funds and ETFs, prospectus reviews of hypothetical pro-forma performance data, continuous disclosure reviews of money market funds, ETFs and investment portfolio holdings, and disclosure reviews of Independent Review Committees.

The OSC's outreach and consultation practices are also discussed, including its publication of the Investment Funds Practitioner and the creation of the new Investment Funds Product Advisory Committee. For more information, see OSC Notice 81-716.

BCSC grants limited relief from its new private placement disclosure form

As we discussed last September, this past August and earlier this week, private placements in British Columbia will soon be subject to expanded post-trade disclosure requirements. The requirements to be imposed on foreign issuers and Canadian private issuers were expected to have a chilling effect on private placements into the province as detailed in our previous posts. The new requirements, found in Form 45-106F6, are set to come into force on October 3rd.

Earlier today, however, the BCSC issued an order exempting investment funds from the requirement to file the new Form 45-106F6, provided that a Form 45-106F1 is filed. Form 45-106F1 is the current form required to be filed in a Canadian jurisdiction under NI 45-106 Prospectus and Registration Exemptions.

Meanwhile, issuers and underwriters filing the report in respect of private placements by certain foreign public issuers (defined to include issuers subject to prescribed reporting requirements in the U.S. and certain other designated jurisdictions) will now be exempt from Item 4 of the new report, being the requirement to provide information regarding the securities beneficially owned or controlled by their insiders and promoters. The designated jurisdictions are Australia, France, Germany, Hong Kong, Italy, Japan, Mexico, the Netherlands, New Zealand, Singapore, South Africa, Spain, Sweden, Switzerland and the U.K. While the order provides relief from Item 4 in respect of these designated foreign public issuers, they must still file the report in compliance with the remaining provisions. No relief was extended to Canadian private companies.

The BCSC also concurrently published an order exempting representatives of the media from the prohibition against using information contained in Schedule I of the report provided they only disclose the information for journalistic purposes. The information contained in Schedule I includes the name of individual purchasers, the number and type of securities they purchased and price paid, the date of distribution and indication of whether the purchaser is an insider or a registrant.

OSC report sets out deficiencies from compliance review of registrants

The OSC today released a report prepared by its Compliance and Registrant Regulation Branch that summarized the new and proposed rules impacting registrants, provided information intended to assist firms and individuals applying for registration, and identified deficiencies found in compliance reviews of registrants. The report primarily covered the OSC's 2011 fiscal year. 

Of particular interest, the deficiencies highlighted by the report include: (i) inaccurate calculations by firms of excess working capital on Form 31-103F1; (ii) inadequate insurance coverage by registered portfolio managers and investment fund managers; (iii) a lack of disclosure by portfolio managers regarding the use of client brokerage commissions; (iv) a delegation of "know your client" and suitability obligations by portfolio managers; (v) EMDs selling exempt securities in reliance on the accredited investor exemption to investors who do not meet the definition; (vi) individuals trading on behalf of EMDs without being registered as a dealing representative with the EMD; and (vii) EMDs inappropriately using investor funds.

The report also provides a number of suggested practices to assist registrants in addressing the various identified deficiencies. Guidance was also included concerning such issues as the use of social media, marketing practices and the provision of online advisory services. For more information, see OSC Staff Notice 33-736.

Expanded disclosure requirements in BC could have chilling effect on private placements

As we discussed in a blog post of August 16, the British Columbia Securities Commission recently announced that, effective October 3, 2011, exempt distributions (private placements) in British Columbia will be subject to expanded post-trade disclosure requirements. These new rules are expected to have a chilling effect on private placements into British Columbia, particularly by foreign public companies and investment funds, and other issuers that are not “reporting issuers” (public companies) in Canada.

While issuers making an exempt distribution in B.C. will generally be required to file the new Form 45-106F6 (in addition to filing a Form 45-106F1 in other Canadian jurisdictions, as applicable), issuers that are not reporting issuers in any jurisdiction of Canada will have to comply with more onerous requirements. As we mentioned in our earlier blog post, however, an exempt distribution report on the new Form and on Form 45-106F1 will only be required for distributions effected pursuant to prescribed prospectus exemptions. The practical feasibility of collecting the required information and the fact that the additional information will be publicly accessible must be carefully considered by issuers before they decide to make a private placement in British Columbia.

Specifically, the new form will require non-reporting issuers to provide disclosure in the main body of the report regarding the securities beneficially owned, or directly or indirectly controlled, by each insider and promoter of the issuer. The term “insider” under British Columbia securities legislation captures a wide range of persons including, for example, directors and officers of entities holding more than 10% of the voting rights of the issuer. Investment funds managed by an investment fund manager registered in a Canadian jurisdiction, however, will not have to provide the additional information. Importantly, the required information will include the price paid for all securities held by the insider or promoter and their directors and officers on the distribution date, including securities previously acquired. Underwriters and issuers, particularly those involved in global offerings by major non-Canadian issuers will likely face significant practical difficulties in collecting, vetting and disclosing the required information within the prescribed 10-day timeframe for filing. Also, since the information will be required in the main body of the form, it will be publicly accessible in electronic form.

As such, non-reporting issuers should carefully consider these new requirements before undertaking an exempt distribution in British Columbia. Those continuing to make exempt distributions in British Columbia after October 3 should review their subscription and other related documentation to ensure they are obtaining the information necessary to fulfill these new reporting requirements.

For more information, see our blog post of August 16, cited above.

Regulators' IFM delegation concerns shouldn't affect trustees

Darin Renton -

As we discussed recently, Canadian registration rules were amended in July with the stated intention of improving the day-to-day operation of the rules for both industry and regulators. Of interest to investment fund managers, the amendments revised the guidance in the Companion Policy to NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations regarding how the investment fund manager registration requirement applies to various fund structures. Specifically, section 7.3 of the Companion Policy now states as follows: 

***

 

 Investment fund complexes or groups with more than one investment fund manager

Some investment fund complexes or groups may have more than one entity within the fund complex that can be considered as directing the business, operations or affairs of an investment fund. For example, structures where investment funds are organized as limited partnerships may have multiple entities within the fund complex that could require investment fund manager registration. Although the investment fund manager functions are often delegated to one entity within the fund complex, there may be more than one entity in the group subject to investment fund manager registration, absent an exemption from registration.

We will consider exemption applications on a case-by-case basis to allow only one investment fund manager within the fund complex to be registered. We will typically consider the following factors when reviewing such applications:

  • there is a management agreement in place delegating all or substantially all of the investment fund management function from the investment fund manager seeking the relief to an affiliate (or to an entity whose mind and management is the same) that is registered as an investment fund manager
  • the majority of the investment fund management functions are performed by the registered affiliate (or entity whose mind and management is the same)
  • the investment fund manager seeking the relief and the registered affiliate have directors and officers in common 
***

The language in the Companion Policy is of concern, as it appears to suggest that exemptive relief may be required in order to delegate investment fund management responsibilities within a family of funds in all cases. OSC Staff have subsequently confirmed, however, that the guidance is not directed at boards of directors of corporate issuers or trustees of trusts. According to the OSC, regulators take the view that boards and trustees can in fact delegate investment fund management responsibilities, provided the delegation is structured properly.

Apparently, concern remains in respect of general partners of limited partnerships, as the regulators are concerned that general partners may not be able to delegate in the same manner as a board of directors or trustees. On this point, the CSA take the position that the delegation must be "to an affiliate (or to an entity whose mind and management is the same) that is registered as an investment fund manager." Accordingly, the CSA are expecting limited partnerships and their general partners to seek exemptive relief to make the IFM delegation.

SEC requests comments on use of derivatives by investment companies

On August 31, the U.S. Securities and Exchange Commission issued a concept release on the use of derivatives by mutual funds and other investment companies registered under the Investment Company Act of 1940. In the release, the SEC noted the "dramatic growth" in the complexity and volume of derivatives investments in recent years and, specifically, funds' increased use of such investments.

The release is ultimately intended to assist the SEC in determining whether further regulation or guidance is needed to improve the regulatory regime with respect to funds' use of derivatives. To that end, the release considers, and requests comment on, such issues as: (i) the costs, benefits and risks of funds' use of derivatives; (ii) restrictions on leverage; (iii) portfolio diversification and concentration; (iv) exposure to securities-related issuers; and (v) the valuation of derivatives.

Comments are being accepted by the SEC for 60 days after the publication of the release in the Federal Register.

Prospectus required for cross-listed ETFs: OSC Staff

Staff of the Ontario Securities Commission today released a notice setting out their views on the application of prospectus requirements and product regulation in connection with cross-listings by foreign exchange-traded mutual funds.

According to OSC Staff, an ETF's exchange listing functions are "the primary distribution channel through which an ETF issues its securities to investors and increases its net assets". As such, OSC Staff do not consider a listing to merely provide a source of secondary market liquidity and a cross-listing would, thus, generally be considered a distribution in Ontario.

Foreign ETF providers must, therefore, file a prospectus and comply with investment fund product regulation before applying to cross-list on an exchange in Ontario. Foreign providers of comparable products that use a similar distribution structure would also fall under the same requirements.

OSC Staff indicated that they intend to monitor the issue and potentially consider whether a modified approach to cross-listing of foreign investment products is warranted. Staff also stated that they are open to considering exceptions to their approach. For more information, see OSC Staff Notice 81-715.

Proposed amendments for stage 2 of point of sale disclosure for mutual funds

On August 12, the Canadian Securities Administrators (CSA) published for comment amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure (NI 81-101), Form 81-101F3 Contents of Fund  Facts Document and Companion Policy 81-101CP Mutual Fund Prospectus Disclosure (the Proposed Amendments). The Proposed Amendments, together with consequential amendments, set out Stage 2 of the CSA’s implementation of the point of sale disclosure framework published in 2008. 

The Proposed Amendments will, among other things, require the delivery of the Fund Facts to investors within two days of their purchase of the fund, permit the delivery of the Fund Facts to satisfy the current prospectus delivery requirements under securities legislation and eliminate the current requirement to deliver the simplified prospectus (which will be required to be provided to investors upon request).

The Proposed Amendments are Stage 2 of a three-stage process. Stage 1 (completed on January 1, 2011 and discussed in our post October 28, 2010) required mutual funds subject to NI 81-101 to produce and file the Fund Facts and make it available on the mutual fund’s or mutual fund manager’s website. Stage 3 will consider point of sale delivery for other types of publicly offered investment funds. The comment period expires on November 10, 2011.

CSA provide update on modernization of publicly offered investment funds regulation

The Canadian Securities Administrators published a notice yesterday providing an update on the project to modernize investment fund product regulation. As we discussed in June 2010, the first phase of the project involves amending NI 81-102 Mutual Funds and NI 81-106 Investment Fund Continuous Disclosure to codify exemptive relief that is frequently granted to mutual funds and other investment funds and replace the patchwork orders with uniform requirements. Amendments to that end were proposed last year and, according to yesterday's notice, the CSA intend to publish the amendments in final form by the end of the summer.

Meanwhile, Phase 2 of the modernization project involves identifying and addressing issues concerning market efficiency, investor protection and fairness that arise out of the differing regulatory regimes that apply to different types of publicly offered investment funds. A stated aim of this phase, which is to be implemented in two stages, is reducing the potential for regulatory arbitrage. The first stage would include adopting proposals for restrictions and operational requirements for non-redeemable investment funds analogous to those in NI 81-102 in order to address investor protection and fairness concerns. The CSA plan to publish such proposals for comment in early 2012. During the second stage of this phase of the project, the CSA intend to consider whether certain investment restrictions in NI 81-102 should be loosened in recognition of product and market developments.

Public comments on the proposals are being accepted until July 25, 2011.

OSC's Investment Funds Practioner discusses issues in exemptive relief applications and public disclosure filings

The Ontario Securities Commission recently released the May 2011 issue of its Investment Funds Practitioner. The publication discusses various issues arising out of the OSC's review of the public disclosure documents and applications for exemptive relief filed by investment funds and provides the OSC's responses to the various matters.

Specifically, the OSC provides its views on, among other things, applications for exemptive relief from the requirement to calculate daily net asset value of an investment fund that uses specified derivatives (generally, the OSC believes that calculating NAV on a daily basis doesn't create a significant burden); whether the chief compliance officer of the manager is an "executive officer" for the purposes of requiring a PIF (the OSC answered this in the affirmative); and whether an issuer can make use of a short form prospectus for a subsequent offering within a year of filing a long form prospectus in connection with its IPO (the OSC provides that in such a case, a new fund's continuous disclosure record is not comprehensive enough).

Notably, the Practitioner also provides a number of frequently asked questions (and the OSC's response) regarding the newly-introduced requirements to produce and file Fund Facts documents. The FAQs review such issues as the transition period, filing fees, frequency of filing, the format of Fund Facts and disclosure of past performance.

CSA provide update on IFRS transition for investment funds

On April 12, the CSA published a notice regarding the adoption of IFRS by Canadian investment funds. As we discussed in a blog post of March 24, the CSA recently decided to delay the implementation of IFRS for investment funds to reflect the decision by the Canadian Accounting Standards Board to defer the transition to IFRS for investment companies to January 1, 2013.

In light of the delay by the IASB in publishing for comment a proposal to exempt investment companies from consolidating entities that they control, and the deferral of the IFRS transition date, CSA staff now intend to implement previously proposed IFRS-related amendments to National Instrument 81-106 Investment Fund Continuous Disclosure, subsequent to review and revision, prior to January 1, 2013.

OSC releases review of investment fund disclosure related to IRCs

Earlier today, the Ontario Securities Commission released the findings of its disclosure review related to National Instrument 81-107 Independent Review Committee for Investment Funds. NI 81-107 requires that an investment fund that is a reporting issuer have an independent review committee (IRC) to oversee decisions involving conflicts of interest faced by the fund manager in the operation of the fund. The OSC's review was primarily intended to assess the concerns expressed by the funds industry regarding the implementation of NI 81-107.

Ultimately, the OSC's review made three main findings: (i) IRC fees, which the OSC found range between 0.000033% and 0.27% of a fund's total net assets, represent a "minimal portion" of such assets; (ii) all funds reviewed were able to create and retain an IRC under the rule; and (iii) standing instructions on conflict of interest matters enable the fund manager to effectively manage fund operations. The OSC also identified one "recurring disclosure deficiency of significance", being that some funds failed to disclose IRC fees as a separate line item in financial statements as required by NI 81-106.

Going forward, OSC Staff expect to continue to inquire about the process and criteria used by IRCs to arrive at positive recommendations or approvals of conflict of interest matters. According to the OSC, in such cases, Staff may request the minutes of an IRC's discussion or ask to speak with the IRC or the IRC Chair to discuss a specific matter. OSC Staff will also continue to consider new applications for exemptive relief from the legislated conflict of interest prohibitions in cases where fund managers demonstrate a compelling need or market necessity for the relief. To that end, fund managers were encouraged in the OSC's notice to contact the OSC before proceeding with exemptive relief applications not previously granted and beyond the scope of exemptions codified under NI 81-107. For more information, see OSC Staff Notice 81-713.

CSA further delay implementation of IFRS for investment funds

The Canadian Securities Administrators yesterday released an updated version of Staff Notice 81-320, first published on October 8, 2010, regarding the adoption of IFRS by investment funds (as defined in securities legislation and subject to National Instrument 81-106 Investment Fund Continuous Disclosure) in Canada. The revised version of the notice reflects the recent decision by the Canadian Accounting Standards Board to further defer the transition to IFRS for investment companies to January 1, 2013. In the meantime, investment funds are expected to continue to provide appropriate disclosure about the anticipated impact of the changeover to IFRS in accordance to the guidance provided in Staff Notice 52-320.

OSC staff provides views of investment fund prospectus disclosure

The OSC released a notice today setting out the views of OSC Staff on the disclosure required by investment funds that use Form 41-101F2 (pre-IFRS version, IFRS version) when filing prospectuses. The notice addresses Staff's concerns regarding investment funds departing from the form's general requirements relating to the use of plain language, brevity and the ordering of information and use of headings.

First, in Staff's view, cover page and prospectus summary disclosure tends to be overly detailed, in contrast to Staff's expectations that it include a brief description of the investment fund and the securities to be distributed. As such, Staff specifically request that cover page disclosure be limited to the disclosure specifically mandated by the form, while prospectus summary disclosure generally only provide a brief summary of information that appears elsewhere in the prospectus.

On the other hand, with respect to disclosure about investment objectives, OSC Staff expressed concern regarding the limited nature of disclosure regarding the nature of the returns that the investment fund seeks to provide to investors. The notice specifically reminds filers to comply with all aspects of Item 5 of the form.

Finally, the notice describes the recent filing of prospectuses that combine disclosure for multiple ETFs in the same document. In response to this development, the notice states that the number of investment funds offered in a prospectus should be limited to investment funds with "substantially similar investment objectives, strategies and features." According to Staff, where the number of investment funds incorporated into one prospectus interferes with the presentation of key information in a clear, concise and comparable format, filers will be requested to separate the investment funds into different prospectus documents.

For more information, see OSC Staff Notice 81-714.

CSA provide guidance on early use of fund facts

The Canadian Securities Administrators yesterday published guidance regarding the use of a "Fund Facts" document to an satisfy current prospectus delivery requirements. While amendments to NI 81-101 Mutual Fund Prospectus Disclosure to finalize requirements to produce and file the Fund Facts document became effective on January 1, 2011, the use of the Fund Facts will not be mandatatory until later this year. Yesterday's notice, however, anticipates requests by investment funds for exemptive relief to use the Fund Facts before their mandatory use (April 8, 2011 to begin filing the Fund Facts documents with prospectuses, while funds will have until July 8, 2011 before the Fund Facts documents must be filed for each class or series of securities of the mutual fund).

As such, the guidance sets out a number of terms and conditions that the CSA anticipates requiring as part of such an exemption:

Filing requirements

  • The mutual fund must file a Fund Facts in compliance with Form 81-101F3 Contents of Fund Facts Document.
  • An amendment to the simplified prospectus (SP) must be filed to specify, under Item 3 of Part A of Form 81-101F1 Contents of Simplified Prospectus, that the Fund Facts is incorporated by reference into the SP.
  • A mutual fund must continue to file the SP and annual information form (AIF), as required by securities legislation.

Availability of documents

  • The Fund Facts must continue to be made available to investors on the mutual fund’s or mutual fund manager’s website and delivered or sent to investors free of charge upon request.
  • A mutual fund’s SP and AIF must continue to be delivered or sent to investors free of charge upon request.

Delivery requirements

  • A Fund Facts must be delivered in accordance with the current prospectus delivery requirements under securities legislation.
  • The current withdrawal and rescission rights under securities legislation that apply to delivery of, and failure to deliver, the prospectus will apply to delivery of, and failure to deliver, the Fund Facts. These rights must be disclosed in or with the Fund Facts.
  • A Fund Facts may only be bound with other Fund Facts that are being delivered at the same time within the current prospectus delivery requirements for mutual funds purchased by the investor.

Expiry of exemptive relief

  • Any exemptive relief granted will expire upon the coming into force of any legislation or rules relating to delivery of the Fund Facts to satisfy the prospectus delivery requirements under securities legislation. This is commonly referred to as a “sunset clause”.

According to the CSA, other terms and conditions may also be considered. For more information, see CSA Staff Notice 81-321.

OSC approves amendments to MFDA minimum capital requirements

The Ontario Securities Commission (OSC) announced today that it has approved amendments to MFDA Rule 3.1.1, intended to harmonize the MFDA's minimum capital requirements with those under National Instrument 31-103 Registration Requirements and Exemptions, as well as amendments to Form 1 - Financial Questionnaire and Report. The amendments, which were also approved by various other jurisdictions, are conditional on the MFDA submitting proposed amendments to Form 1 to include a definition of "market value" of securities to regulators for review and approval by March 31, 2011.

Minister of Finance approves implementation of "fund facts" disclosure

As we discussed in an earlier post, the CSA published amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure, its companion policy and related forms in October in furtherance of their project to implement point of sale disclosure for mutual funds. The Ontario Minister of Finance has now approved the amendments, with minor modifications, which will become effective on January 1, 2011.

The Minister also recently approved the IFRS-related amendments referred to in our post of October 1 (with minor modifications). Generally, the amendments affect continuous disclosure rules, prospectus rules, certification rules and registration materials and also come into force on January 1, 2011.

OSC Staff highlight deficiencies and express concerns regarding use of side letters by investment funds in Compliance and Registrant Regulation Branch Report

As we discussed in our post of October 22, the Compliance and Registrant Regulation Branch’s annual report for fiscal 2010 reviews deficiencies identified by staff of the Ontario Securities Commission (OSC) in its review of advisers, investment fund managers and dealers. The Report also highlights initiatives taken by the OSC relating to registrant regulation and provides staff guidance on dealing with identified deficiencies. In a departure from prior reports, the fiscal 2010 report also covers the introduction of the new registration regime, reorganization of the Compliance and Registrant Regulation Branch and common deficiencies found in reviews of registrant applications.

With respect to ongoing compliance requirements, the Report indicates that the percentage of registrants requiring "significantly enhanced compliance" increased from 32% in 2009 to 50% in 2010. Compliance reviews resulting in referral to the Enforcement Branch also increased from 4% in 2009 to 10% in 2010. In addition to general guidance applicable to all registrants, the Report also includes OSC staff views on specific issues relating to investment fund managers, portfolio managers and exempt market dealers, some of which are highlighted below.

Investment fund managers

Investment fund managers will want to pay particular attention to section 3.3 of the Report, which describes OSC staff concerns surrounding non-prospectus investment funds that enter into “side letters” with one or more investors, giving preferential rights and terms to such investors as compared to other investors of the same class of fund units. Examples of such “preferential treatment” noted include preferential portfolio transparency, redemption rights, fund reporting and management and fund performance fees. Citing their concern about “disadvantaging” other investors, staff state that side letters giving such preferential treatment can harm the fund and its other investors through, for example, allowing investors who have portfolio transparency and more frequent redemption rights the opportunity to act on such rights and redeem units before others.

According to the Report, investment fund managers that provide such side letters fail to meet the standard of care prescribed under section 116 of the Securities Act (Ontario), which also requires they exercise their powers and discharge their duties honestly, in good faith and in the best interests of the investment fund. Further, the staff have taken the position that such preferential treatment is a material conflict of interest that requires identification under s. 13.4(1) of NI 31-103 Registration Requirements and Exemptions, and to which a firm must respond under s. 13.4(2).

As such, staff suggest that investment fund managers avoid entering into side letters that provide preferential treatment to some investors, and consider instead creating separate classes of units if different rights and terms are required. They also suggest that rights and terms attaching to each class of units be disclosed in the fund’s offering documents.

Other deficiencies specific to investment fund managers include: (i) offering documents that suggest that net asset value (NAV) calculation errors will not be adjusted retroactively and (ii) prohibited investments made by the fund.

Portfolio managers

Section 3.2 of the Report focuses on portfolio managers and highlights deficiencies identified through the Branch’s normal course compliance reviews. This section also deals with the OSC’s in-progress sweep of marketing practices and new or proposed rules that will impact portfolio managers. Among the identified deficiencies, staff note that some portfolio managers rely on mutual fund salespersons or financial planners to perform KYC-related duties, such as meeting with clients to assess investment needs and risk tolerance. According to the Branch, this action is contrary to securities laws, as registrants may not delegate their obligations respecting KYC and suitability.

The Report also highlights the Branch's concerns with portfolio managers that market performance returns achieved by their advising representatives while employed at another firm. Their concerns relate to marketing of performance returns that were not generated by the advising representative or where the other firm employed a different investment strategy employed. While they cite prohibitions on making misleading statements under section 2.1 of OSC Rule 31-505 Conditions of Registration, staff do acknowledge and explain, however, the limited circumstances in which such marketing may not be misleading. Other issues considered include best execution obligations and risk management and internal controls.

Exempt market dealers

OSC staff based their selection of Exempt Market Dealers (EMDs) reviewed in response to risk assessment questionnaires which were sent to all EMDs registered in Ontario. According to the Report, many EMDs fail to collect and document client information necessary to satisfy KYC and suitability obligations. The Report also cites insufficient disclosure to clients regarding investment products and notes that a number of EMDs reviewed did not have an adequate compliance system to ensure compliance with securities legislation.

According to the Branch, the Report can serve as a self-assessment tool for registrants to strengthen compliance and improve internal controls. As part of its mandate to foster a culture of compliance through outreach and other initiatives, the Report also refers registrants to the updated section of the OSC website entitled “Information for Dealers, Advisers and Investment Fund Managers”, which provides further information about the registration process and ongoing obligations under the new registration regime.

OSC staff provide views on closed-end investment fund conversions

Ontario Securities Commission staff today released their views on the regulatory issues surrounding the conversion of closed-end funds into mutual funds. Specifically, OSC staff identified a number of issues.

Conversion process

According to OSC staff, the conversion process must be transparent to investors. Closed-end funds with a built-in conversion feature should make disclosure regarding the conversion prominent in the fund's initial prospectus. Closed-end funds without a built-in conversion feature should include disclosure regarding the possible conversion and the contemplated process in the initial prospectus. If the conversion is not contemplated at the time of the initial prospectus, OSC staff expect that the decision to convert will trigger the material change reporting requirements. Investors should be provided with sufficient written notice (60 days is suggested in instances where securityholder approval is not sought) before the conversion of the fund. Further, OSC staff expect that investors will be provided with a redemption right prior to the typical suspension of redemptions.

Post-conversion compliance with NI 81-102

Closed-end funds with a built-in conversion feature are expected to comply with NI 81-102 Mutual Funds from inception (or seek exemptive relief at the time of filing the initial prospectus), while those that contemplate conversion after the fact are expected to consider if any modifications are needed to the features or investment strategies of the fund to ensure compliance with NI 81-102 upon conversion. Where fundamental changes to such things as the fund's investment objectives or strategies are anticipated, securityholders of the fund should be given the opportunity to vote on these changes. If an issuer requests exemptive relief to permit a mutual fund to show pre-conversion performance (which is not permitted by s. 15.6 of NI-81-102), the OSC will consider whether such past performance is relevant and useful and will be appropriately presented and qualified as necessary.

Conversion costs

OSC staff expect that fund managers will absorb the merger costs where conversions are structured as a merger between the closed-end fund and a mutual fund.

For more information, see OSC Staff Notice 81-711.

Canadian proposal regarding the registration of "international" and domestic investment fund managers

Non-Canadian fund managers urged to thoroughly review implications

As we recently discussed, on October 15, 2010, the Canadian Securities Administrators (CSA) published proposed amendments to National Instrument 31-103 – Registration Requirements and Exemptions (NI 31-103) related to the registration of (i) investment fund managers who carry out investment fund management activities from a location outside of Canada (International IFMs), and (ii) domestic Canadian investment fund managers with a head office in one Canadian province or territory and who carry out investment fund management activities in other provinces or territories (Domestic IFMs). While NI 31-103 currently provides temporary exemptions from registration for such investment fund managers, the proposed amendments are intended to be adopted prior to the expiration of the temporary exemptions on September 28, 2011, meaning that investment fund managers required to be registered must be registered by that date. The CSA are accepting comments on these proposals until January 13, 2011 and specifically invited comments from investment fund managers.

The proposals raise a number of critical issues, in particular, for International IFMs of non-Canadian investment funds which have admitted Canadian investors through direct offerings of fund securities into Canada or as a result of secondary transactions with Canadian-resident purchasers. The proposed exemptions described below are technical and highly fact-specific. The issues raised by the proposals will be particularly complex in the case of non-Canadian funds with a significant Canadian investor base and non-Canadian funds employing Canadian “feeder” or “blocker”-type vehicles for structuring purposes or Canadian investment vehicles principally established for non-Canadian investors but with a limited number of Canadian-resident investors.

The CSA notice “strongly encourage(s) non-resident investment fund managers to assess their circumstances in advance to determine whether they will need to be registered in any province or territory by September 28, 2011”. Registration as an investment fund manager in any Canadian jurisdiction entails compliance with robust chief compliance officer proficiency, working capital, insurance, financial reporting and other ongoing requirements under Canadian securities laws.

Registration Requirement

An International IFM that carries out investment fund management activities from a location outside of Canada would be required to register as an investment fund manager in the relevant province or territory, if the investment fund it manages has securityholders that are local residents and the International IFM or the fund it manages, has “actively solicited” local residents to purchase securities of the fund. In proposed changes to the companion policy to NI 31-103, the CSA has indicated that they regard “intentional actions to encourage a purchase of [a] fund’s securities” to be active solicitation. Examples they note include: (i) direct communication; (ii) advertising in Canadian publications or other Canadian media including the internet (but not international publications) if the advertising is intended to encourage the purchase of the fund's securities by residents of the jurisdiction; and (iii) purchase recommendations being made by a third party to residents of the jurisdiction, if that party is entitled to be compensated by the investment fund or the investment fund manager for the recommendation itself or for a subsequent purchase of fund securities.

A Domestic IFM that carries out investment fund management activities would be required to register in another province or territory in addition to the province or territory where its head office is located, if the fund has security holders that are local residents and the Domestic IFM, or the fund it manages, has “actively solicited” local residents to purchase securities of the funds.

Canadian securities laws define an “investment fund manager” as a person or entity that directs the business, operations or affairs of an investment fund. The investment fund manager registration requirement also turns on whether or not the funds managed by the manager are “investment funds” for the purposes of Canadian securities laws. 

Proposed Exemptions

The International IFM Exemption

An International IFM would not need to register as an investment fund manager if all the following conditions are met:

  • The securities of the investment fund it manages are distributed only to “permitted clients” (as defined in NI 31-103, and which generally means institutional and high net worth individual investors);
     
  • It does not have a physical place of business in Canada;
     
  • The investment fund it manages is incorporated, formed or created under the laws of a foreign jurisdiction. Significantly, this condition effectively disqualifies investment fund managers who manage from outside Canada funds that are created in Canada;
     
  • The investment fund it manages is not a “reporting issuer” (i.e. a fund issuing securities under a Canadian prospectus) in any jurisdiction of Canada;
     
  • It has submitted to the relevant securities regulatory authorities a form of submission to jurisdiction and appointment of agent for service; and
     
  • It does not have a "significant presence" in Canada. It would be considered to have a "significant presence" in Canada in either of the following situations: 

    • The fair value of all of the assets attributable to Canadian securityholders of any investment fund for which it acts as investment manager is more than 10% of the fair value of all the assets of such fund; 
       
    • The fair value of all of the assets of all investment funds managed by it that are attributable to Canadian securityholders is more than C$50 million.

Grandfathering Exemption

Where an investment fund manager that has no physical presence in a Canadian jurisdiction, was not incorporated, formed or created in such jurisdiction, and the fund it manages is not a reporting issuer and is not incorporated, formed or created in such jurisdiction the investment fund manager would be exempt from the investment fund manager registration requirement if neither the investment fund manager nor the investment fund it manages has “actively solicited” residents of such jurisdiction after September 28, 2011. It is important to note that while there is no “significant presence” threshold currently attached as a condition to reliance on this grandfathering exemption, both the Ontario Securities Commission and the Autorité des marchés financiers du Québec have specifically requested comments on whether such a condition should be applied.

Reliance on either exemption will require that the investment fund manager provide notice to investors informing them of its non-resident status, as well as the risk that investors may not be able to enforce legal rights in the province or territory.

For more information, contact Kathleen G. Ward or Jeffrey Elliott in Toronto, Kenneth G. Ottenbreit or Terence W. Doherty in New York, or Alix d'Anglejan-Chatillon or Jason Streicher in Montréal.

CSA move to implement mutual fund point of sale disclosure

On October 8, the Canadian Securities Administrators (CSA) published amendments to National 81-101 Mutual Fund Prospectus Disclosure, its companion policy and related forms in furtherance of their project to implement point of sale disclosure for mutual funds. As we discussed in earlier posts of June 2009 and June 2010, the CSA intend to proceed with a staged implementation of the project, with the first stage being the finalization of requirements respecting the preparation and filing of a "fund facts" document.

To that end, the amendments released this month, which take into account feedback received on the CSA's 2009 proposals, set out the content and filing requirements of the fund facts document.  To be filed concurrently with a mutual fund's simplified prospectus and annual information form, the document will "highlight key information that is important to investors" in plain language. The document will also have to be made available on a mutual fund's or manager's website.

The CSA expect that the amendments will come into force on January 1, 2011. Mutual funds will be given until April 8, 2011 to begin filing fund facts documents with prospectuses, while funds will have until July 8, 2011 before fund facts documents must be filed for each class or series of securities of the mutual fund. Later stages of the CSA's project will consider point of sale delivery for other types of publicly offered investment funds.

OSC and AMF request additional comment on thresholds to proposed investment fund manager registration exemptions

As we discussed earlier this month, the CSA recently proposed amendments to National Instrument 31-103 Registration Requirements and Exemptions (31-103) relating to the registration of international investment fund managers and registration of domestic investment fund managers in additional provinces and territories.

Under the proposals, specific thresholds would preclude an international investment fund manager from relying on the exemption from registration. Similar thresholds, however, were not included for non-resident investment fund managers. As such, the Ontario Securities Commission and the Autorité des marchés financiers have issued an additional request for comments on whether threshold limitations proposed for international investment fund managers should also be applied to non-resident investment fund managers.

Comments on the issue are being accepted until January 13, 2011. For more information, see CSA Notice 31-320.

OSC releases IF Branch and CRR Branch annual reports

On October 15, the Ontario Securities Commission (OSC) released its Investment Funds Branch Annual Report for 2010 as well as its Compliance and Registrant Regulation Branch Annual Report.

The Investment Funds Branch (IF) report provides an overview of the IF Branch's major policy initiatives for the year (including with respect to the CSA's point of sale project and the modernization of investment fund product regulation) and also describes the IF Branch's ongoing reviews of the prospectus and continuous disclosure filings of Ontario-based investment funds.

Meanwhile, the Compliance and Registrant Regulation (CRR) Branch report summarizes the CRR Branch's activities and initiatives for the year (including, notably, with respect to registration reform), provides information for firms and individuals applying for registration for the first time and reviews its findings for the normal course reviews it conducted of regulated registrants. With respect to the latter, the CRR Branch found that the percentage of firms requring "significantly enhanced compliance" rose from 32% in fiscal 2009 to 50% in fiscal 2010. Meanwhile, referrals to the enforcement branch due to serious breaches of securities law jumped from 4% to 10% of field reviews.

General deficiencies identified by the CRR Branch included improper marketing practices on the part of large portfolio managers, inadequate written policies and procedures on the part of newly registered portfolio managers and prohibited investments for investment funds.

For more information, see OSC Staff Notice 81-712 and OSC Staff Notice 33-734.

CSA propose amendments regarding registration of investment fund managers

The Canadian Securities Administrators (CSA) today proposed amendments to National Instrument 31-103 Registration Requirements and Exemptions (31-103) relating to the registration of international investment fund managers and registration of domestic investment fund managers in additional provinces and territories. While 31-103 currently provides temporary exemptions from registration for such investment fund managers, the proposed amendments are intended to be enacted prior to the expiration of the temporary exemptions on September 28, 2011.

Generally, the CSA proposals would require an international investment fund manager to register in a province or territory if the investment fund it manages has local securityholders and the manager, or the fund, has actively solicited local residents to purchase securities of the fund. Domestic investment fund managers would be required to register in another province or territory (in addition to the Canadian jurisdiction in which its head office is located) if the securityholders are local residents of the province or territory and the manager or the fund has actively solicited local residents to purchase securities of the funds.

Meanwhile, the CSA proposed an exemption from the registration requirement for international investment fund managers where the fund it manages is only distributed to permitted clients, subject to certain conditions and thresholds. For the benefit of non-resident investment fund managers, a grandfathering exemption would be available where neither the investment fund manager nor the investment fund has actively solicited local residents after September 28, 2011.

Further, a new notice requirement that would require all investment fund managers to provide a notice to investors regarding non-resident status and the associated risk to investors was also proposed. The Companion Policy to NI 31-103 would also be amended under the proposals to provide guidance on the CSA's interpretation of the registration requirement as well as the term "actively solicited".

The CSA is accepting comments on its proposals until January 13, 2011.

CSA delay implementation of IFRS for investment funds

The Canadian Securities Administrators (CSA) published an update today regarding their plans for requiring adoption of IFRS by Canadian investment funds. As we discussed in October 2009, the CSA proposed amendments to NI 81-106 Investment Fund Continuous Disclosure last year that would have required investment funds to transition to IFRS by January 1, 2011. The Accounting Standards Board (AcSB) recently decided, however, to defer the mandatory IFRS changeover date for investment companies in order to give the International Accounting Standards Board time to implement a proposed exemption for investment companies from having to consolidate investments they control. As the CSA would prefer that the proposed IASB consolidation exemption be in place before requiring investment funds to transition to IFRS, the CSA intend to wait before seeking approval for, or republishing IFRS-related amendments to NI 81-106. The new goal for IFRS implementation for investment funds is now January 1, 2012.

See: CSA Staff Notice 81-320

OSC releases 2010 Annual Report

Earlier this week, the Ontario Securities Commission released its 2010 Annual Report, which provides a review of the OSC's activities over the past year. Of particular interest, the report discusses various compliance issues associated with the implementation of registration reform, IFRS and corporate sustainability reporting. The report also reviews the results of compliance reviews of registrants, public companies and investment fund issuers.

MFDA proposes amendments to minimum capital requirements and financial questionnaire and report

The Mutual Fund Dealers Association of Canada (MFDA) proposed amendments today to MFDA Rule 3.1.1 that are intended to ensure that MFDA Members registered in other registration categories under Canadian securities legislation are subject to consistent minimum capital requirements under MFDA Rules and National Instrument 31-103 Registration Requirements and Exemptions. The MFDA also proposed amendments today to MFDA Form 1 (Financial Questionnaire and Report) that are intended to to align financial reporting under Form 1 with International Financial Reporting Standards.
 
Comments are being accepted on the proposed amendments to Rule 3.1.1 and Form 1 until October 12, 2010.

SEC proposes mutual fund distribution fee regulations

The Securities and Exchange Commission (SEC) yesterday announced proposals intended to improve the regulation of mutual fund distribution fees and provide enhanced disclosure for investors. Distribution fees, also known as 12b-1 fees, are fees paid by the fund out of its assets to cover distribution costs and shareholder service expenses. The proposals would limit fund sales charges, improve the transparency of fees by requiring funds to identify and more clearly disclose distribution fees, encourage retail price competition and revise fund director oversight duties. The proposals will be open to a 90-day comment period after publication in the Federal Register.

MFDA proposes amendments to regulations re client property, transaction fees and records

The Mutual Fund Dealers Association of Canada (MFDA) proposed amendments today that would remove the existing obligations in MFDA Rule 3.3.2 to hold client cash for investment in mutual funds separately from client cash for other investments. According to the MFDA, however, the protection of client assets would not be impacted as existing requirements to segregate client cash held in trust from Member property would be maintained. The amendments are being proposed in anticipation of similar changes to National Instrument 81-102 Mutual Funds.

Meanwhile, amendments were also proposed to MFDA Rule 2.4.4 regarding transaction fees or charges and Rule 5.1 respecting the requirement for records, in order to require MFDA members to inform investors of transaction fees or charges prior to the acceptance of their order.

Comments are being accepted on the proposed amendments to Rule 3.3.2 until September 24 and until September 23 with respect to the proposed amendments to Rules 2.4.4 and 5.1.

CSA publish proposed amendments to mutual fund and investment fund regulatory framework

The Canadian Securities Administrators (CSA) today published proposed amendments to National Instrument 81-102 Mutual Funds, National Instrument 81-106 Investment Fund Continuous Disclosure and related consequential amendments. The amendments would codify exemptive relief that is frequently granted to mutual funds and other investment funds and is intended to replace a patchwork of exemptive relief orders with uniform requirements. The proposed amendments seek to address the following: exchange-traded mutual funds, investments in other mutual funds, short selling, derivatives, money market funds, mutual fund dealers, mutual fund ratings and continuous disclosure requirements.

Today's amendments are described by the CSA as representing the first phase in modernizing the regulation of conventional mutual funds and other investment funds. The second phase of the project will consider "whether there are any market efficiency, fairness or investor protection issues that arise out of the differing regulatory regimes" applying to different types of investment funds and other competing investment products. The CSA will then consider whether NI 81-102 should be further amended to address such issues.

CSA provide update on mutual fund point of sale disclosure

Staff of the Canadian Securities Administrators (CSA) recently published a notice providing an update on the point of sale disclosure project for mutual funds. The update follows the CSA's consideration of comments to proposed amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure, which were published in June 2009. Despite some compliance concerns by commentators, the CSA made clear in the notice that they remain committed to implementing point of sale disclosure for mutual funds.

The CSA intend to proceed with a staged implementation of the project, which according to the notice, will provide the CSA "the opportunity to continue to consult with stakeholders and to consider the applicability of the point of sale regime for mutual funds to other types of publicly offered investment funds". Specifically, the CSA intend to proceed by first finalizing the requirements respecting the preparation and filing of a "Fund Facts" document, which would be posted on the mutual fund's or manager's website and provided to an investor upon request. The CSA expect to publish such requirements by December 2010, with an effective date in early 2011. Second, the CSA intend to publish for comment, in mid-2011, a proposal to allow delivery of the Fund Facts document to satisfy prospectus requirements to deliver a prospectus within two days of buying a mutual fund. While the CSA work on the proposal, they plan to consider applications for exemptive relief to use Fund Facts to satisfy current prospectus requirements. Finally, the CSA intend to publish requirements for point of sale delivery for mutual funds and possibly for other types of publicly offered investment funds once it has completed the review of relevant issues.

CSA Staff Notice 81-319 Status Report on the Implementation of Point of Sale Disclosure for Mutual Funds

OSC staff set out views regarding change of control of mutual fund manager

The Ontario Securities Commission (OSC) today released OSC Staff Notice 81-710, setting out the views of OSC Staff regarding the circumstances in which staff may view a change of control of the manager of a mutual fund to effectively be a change in the manager requring securityholder approval. According to the OSC, this issue will generally arise if the transaction is structured in one of the following ways: (i) the manager of a mutual fund amalgamates with another investment fund manager; (ii) if, immediately following a change in control of the manager of the mutual fund, a change of manager will occur where the new manager will be the entity that acquired control of the original manager or an affiliate of such entity; or (iii) when it is contemplated that within a foreseeable period of time following a change in control of the manager of the mutual fund, a change of manager of the mutual fund will occur where the new manager will be the entity that acquired control of the original manager or an affiliate of such entity.

US Supreme Court rules on fiduciary duty of investment advisers

On March 30, the Supreme Court of the United States released its decision in the case of Jones v. Harris. The case considered the fiduciary duty imposed on mutual fund advisers by section 36 of the Investment Company Act of 1940 (ICA) with respect to the receipt of compensation for services. This particular issue has been the topic of recent judicial attention.

Ultimately, the Supreme Court accepted the basic formulation of the Gartenberg test, stating that "to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining." While the basic formulation of the test appeared to be relatively uncontroversial in this case, the parties disagreed on a number of points concerning its application. Thus, the Supreme Court provided guidance on a number of issues. Specifically, the Supreme Court stated that: 

  1. since the ICA requires consideration of all relevant factors concerning the fees charged, there is no categorical rule prohibiting comparisons between the fees charged by advisers to different types of clients. The weight to be allocated to such comparisons, however, depends on the circumstances and the ICA does not ensure fee parity between mutual funds and institutional clients;
     
  2. Courts should not rely too heavily on the fees charged by other advisers; and
     
  3. A court's evaluation of an investment adviser's fiduciary duty must take into account both procedure and substance. "Where a board's process for negotiating and reviewing investment-adviser compensation is robust, a reviewing court should afford commensurate deference to the outcome of the bargaining process." Where the board's process was deficient or the adviser withheld important information, however, a court may take a more rigorous look at the outcome.

Finding that the Seventh Circuit panel focused almost entirely on disclosure, the Supreme Court vacated the Circuit Court's decision and remanded the case.

The immediate decision's effect on mutual fund fees remains to be seen, and will ultimately depend on the interpretation given to the Supreme Court's findings by lower courts. Thus, the mutual fund industry will undoubtedly watch with interest as this case, and those like it, proceed through the lower courts.

OSC publishes report regarding review of investment funds

Earlier this week, the Ontario Securities Commission (OSC) issued a report summarizing its compliance review of various types of investment funds. The review began in September 2008 in response to concerns respecting market turmoil and focused on assessing compliance by fund managers with Ontario securities laws. Funds were reviewed in three phases, beginning with money market funds, followed by non-conventional investment funds and finally focusing on hedge funds.

While the OSC noted "some instances of non-compliance" during site visits, the report states that no industry-wide compliance issues were observed. The report, however, makes a number of observations and includes suggested practices for fund managers.

OSC releases January 2010 edition of The Investment Funds Practitioner

The Ontario Securities Commission (OSC) has released the January 2010 edition of The Investment Funds Practitioner, a publication intended to assist those that regularly prepare public disclosure documents and applications for exemptive relief on behalf of investment funds. Authored by staff of the OSC's Investment Funds Branch, the Practitioner contains an overview of recent issues emerging from applications for discretionary relief, prospectuses and continuous disclosure documents. Specifically, the OSC provided a number of observations and practice points that may be of interest. Among other things, the publication considers the following: 

  • Responding to "novel applications" for relief from the various conflict provisions under Ontario's Securities Act (Act) and National Instrument 81-102 Mutual Funds (NI 81-102) based on IRC approval. The OSC reminded filers that the Canadian Securities Administrators deliberately chose to maintain the various conflict provisions in local securities legislation and codify only limited exemptions in National Instrument 81-107 Independent Review Committee for Investment Funds.  The OSC stated that it intends to complete reviews to assess how the IRC approval system is working with existing codified exemptions.
     
  • The OSC noted a number of "recurring issues" respecting the mergers and reorganizations of mutual funds, including applications missing required information and filers failing to properly factor in securities regulatory approval into the transaction planning process.
     
  • The OSC also noted that it generally does not require a parallel application for relief from the conflicts of interest prohibitions under the Act where relief is sought under NI 81-102 to facilitate fund on fund arrangements that do not comply with all the conditions in section 2.5(2) of NI 81-102. The OSC indicated that it is of the view that the exemption codified under section 2.5(7) of NI 81-102 still applies even where the fund has obtained an exemption from some of the conditions in section 2.5(2).   
     
  • Filers were also reminded by the OSC that those wishing to receive a receipt for a (preliminary) prospectus that the (preliminary) prospectus and accompanying material should be received by the OSC on or before noon on the day the receipt is required.
     
  • The OSC noted that while it has granted relief to file a prospectus beyond the 90 day period, it encourages filers to make applications for this type of relief prior to the expiration of the 90 day period.  

CSA publish proposed amendments to investment fund disclosure forms

As described in an earlier post, the CSA recently published the final version of National Instrument 23-102 Use of Client Brokerage Commissions (NI 23-102) and the accompanying companion policy, which relate to soft dollar arrangements. The CSA has now also released proposed amendments to Form 81-101F2 Contents of Annual Information Form and Form 41-101F2 Information Required in an Investment Fund Prospectus. The amendments to the forms are intended to ensure consistency with the disclosure requirements in NI 23-102. Comments are being accepted by the CSA until January 6, 2010.

U.S. Treasury Department proposes hedge fund registration requirements

As described in our post of June 18, the U.S. Treasury Department's financial reform plan included a proposal requiring that investment advisers to hedge funds and other private pools of capital whose assets under management exceed "some modest threshold" be registered with the Securities and Exchange Commission under the Investment Advisers Act. On July 15, the Treasury Department delivered such proposed legislation to Congress.

While some hedge fund managers are currently subject to regulation as “investment advisers” by the SEC under the Investment Company Act of 1940, the majority operate outside the ambit of the SEC as they are organized to qualify for exemptions from registration requirements that generally apply to managers of similar types of investment vehicles, such as mutual funds. The proposed legislation, however, would impose registration requirements on advisers to private investment funds with more than $30 million of assets under management. Funds would be subject to various obligations with respect to financial reporting, conflict of interest prohibitions and increased disclosure requirements. According to the Treasury Department's press release, the new legislation "would help protect investors from fraud and abuse, provide increased transparency, and provide the information necessary to assess whether risks in the aggregate or risks in any particular fund pose a threat to our overall financial stability.

CSA publish proposals respecting mutual fund disclosure at point of sale

On June 19, 2009, the Canadian Securities Administrators (the CSA) published for comment proposed amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure and its related forms.   

The proposed amendments represent the culmination of many years of review and research undertaken by securities and insurance regulators under their Joint Forum initiative to develop a better approach to providing meaningful and effective disclosure to mutual fund investors. As such, the proposed amendments announced in this notice form the first phase of this joint approach. The second phase involves a review of the overall disclosure regime for mutual funds with a view to reducing duplication.

As initially proposed in the Joint Forum’s Proposed Framework published on June 15, 2007 and as revised on October 24, 2008, the proposals focus on the delivery of a simple and concise “Fund Facts” document. In response to comments received on the framework, the regulators have, however, modified their approach to how the Fund Facts document is to be delivered.

As under the Framework, the proposed amendments require the Fund Facts document to be filed concurrently with the mutual fund’s simplified prospectus and annual information form. Managers may, however, choose to periodically update the disclosure by filing an updated document on SEDAR. The document must also be amended if there is a material change to the mutual fund that requires a change to the disclosure set out in the Fund Facts document. In addition, the proposed amendments require the delivery of the Fund Facts document generally for all initial purchases that are recommended to an investor before or at the point of sale, although it is not required to be delivered for subsequent purchases of a mutual fund held in the investor’s account. Dealers will also have to give investors the option to receive the Fund Facts document annually and the most recently filed Fund Facts document will also have to be posted to the website of the mutual fund, mutual fund family or manager.

Feedback is requested, particularly on implementation issues, with a deadline to submit comments of October, 17, 2009.

Treasury Department proposals include regulation of private fund advisors

As described yesterday, the U.S. Treasury Department's "Financial Regulatory Reform: A New Foundation" includes numerous proposals to address perceived inadequacies in U.S. financial regulation. Of particular note, the report proposes requiring that investment advisers to hedge funds and other private pools of capital (including private equity and venture capital funds) whose assets under management exceed "some modest threshold" be registered with the Securities and Exchange Commission under the Investment Advisers Act. Registration of such investment advisers would make them subject to recordkeeping and disclosure requirements, including requirements to report to investors, creditors and counterparties, as well as regulators. While the reporting may vary across the different types of private pools of capital, the report proposed confidential reporting to regulators of the amount of assets under management, borrowings, off-balance sheet exposures and other “necessary” information. As stated in the report, "[r]equiring the SEC registration of investment advisers to hedge funds and other private pools of capital would allow data to be collected that would permit an informed assessment of how such funds are changing over time and whether any such funds have become so large, leveraged, or interconnected that they require regulation for financial stability purposes."

These proposals follow similar proposals made by the G20 in the G20 Working Group 1 Final Report released in March of 2009, which also recommended registration of private pools of capital or their managers. The G20 Report also endorsed enhanced disclosure by such entities, including with respect to size, investment type, leverage, performance and participation in “certain systemically important markets.” As well, the G20 report recommended the development of common metrics to assess the significant exposures of counterparties for hedge funds, including prime brokers, given its view that failure of a systemically important fund or group of funds could be spread to the broader financial system through the use of counterparties.

Following the publication of the G20 Report, the European Commission also proposed its own framework for the regulation of managers of “alternative investment funds” on April 29, 2009. The proposed Directive would apply to any European Union domiciled “alternative investment fund manager” (AIFM) with assets under management above $EUR 100 million, or, for funds with no leverage and a lock-in period of five years or more, assets under management above $EUR 500 million. Under the proposed Directive, all AIFMs falling within the scope of the Directive would be required to be “authorized” by the regulator of their home state. Such authorization would impose a wide range of investment adviser type of requirements, including suitability, disclosure, governance, capital and other requirements. Disclosure requirements would relate to reporting on planned activity, identity and characteristics of the funds managed, governance and internal arrangements (including with respect to risk management, valuation and safe-keeping of assets, audits and systems of regulatory reporting). The manager would also be required to report to the relevant authority on the principal markets and instruments in which it trades, its principal exposures, performance data and concentration of risk. Additional disclosure requirements could also apply to managers managing leveraged funds and controlling stakes in companies.

MSC repeals requirements respecting sale of labour sponsored investment funds

Earlier this month, the Manitoba Securities Commission issued a notice repealing the requirements imposed on mutual fund dealers and salespeople set out in MSC Staff Notice 2001-11 with respect to the sale of Labour Sponsored Investment Funds (LSIFs). The MSC indicated that the imposed requirements were no longer applicable.

CSA respond to potential impact of s. 3855 of the CICA Handbook on investment funds

Daniella Laise |  PDF Version | Version française

On August 12, 2008, the Minister of Finance approved amendments to National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106), that came into force September 8, 2008 (the NI 81-106 Amendments). The NI 81-106 Amendments respond to the potential impact on investment funds following the introduction of Section 3855 Financial Instruments -- Recognition and Measurement of the Canadian Institute of Chartered Accountants (CICA) Handbook (section 3855).

Background

In 2005, the Accounting Standards Board of the Canadian Institute of Chartered Accountants introduced section 3855, which applies to interim and annual financial statements relating to fiscal years beginning on or after October 1, 2006. Section 3855 provides more specific guidance on how to measure financial instruments at fair value for financial statement purposes when fair value measurement is required. To comply with the guidance in section 3855, investment funds would have needed to change how they value a large portion of the securities in their portfolios, particularly those that are traded on a recognized exchange. For example, those securities traded on a recognized exchange would need to be valued at the bid or ask price on each valuation day, as opposed to valued at the closing price, which is predominantly the current valuation practice. 

Prior to the Amendments, section 14.2 of NI 81-106 required investment funds to calculate net asset value in accordance with Canadian generally accepted accounting principles (Canadian GAAP).  Maintaining this requirement after the introduction of section 3855 would mean that investment funds would have to change long-standing industry valuation practices. This would potentially have had adverse consequences to investment fund securityholders. The Canadian Securities Administrators (CSA) granted exemptive relief, permitting investment funds to calculate net asset value for purposes other than financial statements without giving effect to section 3855. This exemptive relief, originally set to end no later than September 30, 2007, was extended until the earlier of (i) September 30, 2008; and (ii) the effective date of the amendments to NI 81-106 to address this issue. As noted, amendments to NI 81-106 were made effective as of September 8, 2008.

Amendments to NI 81-106 in force September 8, 2008

The NI 81-106 Amendments permit investment funds to have two different net asset values: one for financial statement purposes, which is to be prepared in accordance with Canadian GAAP (being referred to as “net assets” under NI 81-106 following the NI 81-106 Amendments); and another for all other purposes, including unit pricing (being referred to as “net asset value” under NI 81-106 following the NI 81-106 Amendments). Under the NI 81-106 Amendments, section 3.6 of NI 81-106 has been amended to require that the notes to the financial statements disclose the net asset value per security as at the date of the financial statements compared to the net assets per security as shown on the statement of net assets and to provide an explanation of the differences between these amounts.

The NI 81-106 Amendments remove the requirement in section 14.2 of NI 81-106 to calculate net asset value in accordance with Canadian GAAP and replace it with a requirement to calculate the net asset value of an investment fund using the fair value of the investment fund’s assets and liabilities. For this purpose, fair value of assets and liabilities means the market value based on reported prices and quotations in an active market (see section 14.2(1.2)(a), NI 81-106). When the current market value is not available or the manager of the investment fund determines that it is unreliable, fair value means a value that is fair and reasonable in all relevant circumstances (see section 14.2(1.2)(b), NI 81-106). The NI 81-106 Amendments require that the manager maintain a record of the determination of fair value and the reasons supporting that determination (section 14.2(1.4)).   Section 14.2 of NI 81-106 has also been amended to require the manager to establish and maintain policies and procedures for determining fair value of the investment fund’s assets and liabilities. Section 9 of the Companion Policy to NI 81-106 has been amended to provide guidance in this regard and provides that the policies and procedures should be approved by the manager’s board of directors. Section 9 of the Companion Policy has also been amended to provide guidance for determining fair value.

Is there anything investment funds currently in existence should be doing?

  • Review and assess internal policies and procedures to  determine what changes, if any, will be required to comply with section 3855 as regards financial statements (in consultation with internal and external auditors).
  • Review constating documents and material contracts to determine if any amendments are required.
    • The constating documents of most investment funds stipulate a methodology for calculating net asset value (for issuances, redemptions, the calculation of management fees, etc.) and if the methodology refers to Canadian GAAP, the fund may need to follow section 3855, unless amendments are implemented. If amendments are necessary, the fund must determine whether those amendments can be implemented without shareholder approval.
  • Contact all service providers and/or pricing or information sources to ensure that net asset value is being calculated appropriately and to ensure that information is available to permit compliance with s. 3855 for financial statement reporting purposes.
  • Consider if a press release or other disclosure is required to inform investors of a change in the valuation methodology.

Is there anything investment funds currently being formed should be doing?

  • Review draft material contracts, including all third party contracts to ensure they accurately reflect the calculation of net assets and net asset value.
  • Review prospectus disclosure to ensure that it accurately describes methods of calculating net asset value.

CSA Notice 81-318 - Request for Comment - Framework 81-406 Point of sale disclosure for mutual funds and segregated funds

The CSA and the Canadian Council of Insurance Regulators, comprising the Joint Forum of Financial Market Regulators, have released their proposed Framework 81-406 Point of sale disclosure for mutual funds and segregated funds. This framework set out concepts and principles reflecting the Joint Forum’s vision for more meaningful and effective disclosure.

Prior to publishing proposed changes to existing securities laws required to implement this framework, the CSA is seeking feedback on the proposal. Comments may be submitted by December 23, 2008.

MFDA publishes proposed amendments to Rule 2.6

The MFDA is publishing for comment proposed amendments to Rule 2.6 Borrowing for Securities Purchases. The proposed amendments would require leverage risk disclosure only when an Approved Person makes a recommendation to invest using borrowed funds or becomes aware of a client borrowing for investment. The proposed amendments would also exempt RRSP loans from the disclosure requirements of Rule 2.6. In conjunction with the proposed amendments, MFDA staff will be revising the prescribed risk disclosure language in MR-0006 to provide a brief explanation of key risks and relevant considerations in plain language. The comment period expires November 3, 2008.

Adoption of Amendments to NI 81-106 Investment Fund Continuous Disclosure

On August 12, 2008, the Minister of Finance approved amendments, to come into force today, regarding investment fund continuous disclosure and the contents of Annual Information Forms. The proposed amendments were originally published on June 20, 2008, and described in our earlier post.

Among other things, these amendments:

  • modify the requirements regarding the calculation of net asset value following the introduction of Section 3855 Financial Instruments - Recognition and Measurement of the CICA Handbook; and
  • clarify/correct certain provisions of NationaI Instrument 81-106 Investment Fund Continuous Disclosure.

SEC announces new AML compliance initiatives

On August 7, 2008, the U.S. SEC announced two new anti-money laundering compliance initiatives. The first, an online reference site, was originally developed for the benefit of SEC examiners and provides links to relevant laws, rules and guidance to assist mutual funds in AML compliance efforts. The second initiative, a centralized SEC SAR Alert Message Line, will allow the reporting of Suspicious Activity Reports that may require immediate attention by the SEC.

OSC Staff Notice 11-763 - A Focused Review of the Securities Valuation and Expense Allocation Practices of Fund Managers

The OSC has published Staff Notice 11-763 to summarize findings from its 2007 review of securities valuation and operating expense allocation of fund managers.

In reviewing the methodologies used to value portfolio securities and practices related to charging of expenses, the Staff Notices states that overall the fund managers reviewed  had adequate policies and procedures, used appropriate valuation techniques, followed practices consistent with their disclosure and were adequately overseeing service providers.  

Notice of Amendments to NI 81-106 Investment Fund Continuous Disclosure

The CSA have approved amendments to NI 81-106, NI 81-106F1 and the related Companion Policy which will also result in changes to NI 81-102 Mutual Funds and the related Companion Policy, Form 81-101F2 Contents of Annual Information Form, and Form 41-101F2 Information Required in an Investment Fund Prospectus.

These amendments, scheduled to come into force on September 8, 2008, have been made further to a proposal and request for comments published on June 1, 2007 and are intended primarily to modify the requirements regarding the calculation of net asset value following the introduction of Section 3855 Financial Instruments -- Recognition and Measurement of the CICA Handbook; and clarify or correct certain provisions of the Instrument.

OSC Notice published on continuous disclosure review of mutual funds

OSC Notice 81-709 summarizes findings relating to the OSC’s continuous disclosure review of conventional mutual funds. The notice primarily highlights compliance issues with NI 81-106 disclosure matters and, while focussed on conventional mutual funds, includes guidance of benefit to closed-end and exchange traded funds.

Round Two of Canada's National Registration Reform Proposal: Impact on "International Dealers" registered in Ontario

Kenneth G. Ottenbreit, Ralph A. Hipsher and Terence W. Doherty | Version française

On February 29, 2008, the Canadian Securities Administrators (CSA) published their revised proposals on National Instrument 31-103 Registration Requirements ("the Instrument"), relating to registration requirements for dealers, advisers and investment fund managers. The proposed registration reforms represent a major restructuring of the Canadian dealer, adviser and investment fund manager registration rules and have implications for non-Canadian dealers, advisers and investment fund managers doing business on a registered or exempt basis in any province or territory of Canada.

The Instrument is intended to create a streamlined and harmonized approach to the regulation of investment activities across Canada. Canada does not have a national or federal securities regulator; securities activities are regulated by Canada's thirteen provincial and territorial securities regulators (the CSA is their umbrella organization).

Proposed changes to the dealer registration and exemption regime

Under the existing rules, non-Canadian dealers typically participate in the Canadian market by being registered as an "international dealer" in Ontario and relying on the "accredited investor" exemption in the other provinces and territories.
The primary effects of the Instrument on non-Canadian dealers are:

  • elimination of the "international dealer registration" category in Ontario; 
  • introduction of a national "international dealer exemption" based on the Ontario "international dealer" registration category with some changes (see below) to the list of exempt "permitted clients";
  • repeal of the dealer registration exemptions contained in National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106), including the exemption for trades with an "accredited investor;
  • elimination of the "limited market dealer" registration category in Ontario; and
  • introduction of a new "exempt market dealer" registration category across Canada.

Current dealer registration and exemption regime

In Ontario, registration as an "international dealer" permits a non-Canadian dealer to trade with "designated institutions" in non-Canadian equity and debt securities and certain Canadian debt securities (primarily in the secondary market). The practical effect of the international dealer registration regime in Ontario is to permit a non-Canadian dealer to trade in permitted securities with institutional clients (not individuals).

Except in Ontario, provincial and territorial securities laws generally permit a non-Canadian dealer to trade in both Canadian and non-Canadian securities with an "accredited investor" on a dealer registration-exempt basis. This exemption has been very widely used by non-Canadian dealers and its proposed elimination is a significant regulatory change.

Proposed international dealer exemption will narrow list of permitted clients outside Ontario

The Ontario "international dealer registration" will be replaced by the similar Canada-wide "international dealer exemption".  Outside Ontario, this represents a very significant narrowing of permitted activities and clients in all of the other (i.e. non-Ontario) provinces and territories.

Under the Instrument, a non-Canadian dealer that is registered under the securities laws of its home jurisdiction may rely on the international dealer exemption to trade with a "permitted client" when trading in "foreign securities". Subject to the filing of submission to jurisdiction forms in each province and territory and delivering client notifications, the practical effect of the proposed international dealer registration exemption is to narrow the list of clients with whom a non-Canadian dealer is permitted to trade on an exempt basis outside Ontario and to require registration as an "exempt market dealer" as a condition to trading with the full range of "accredited investors" in all types of securities.

Under the revised draft of the Instrument, the definition of "permitted client" has been expanded from the previous draft so that it is now very similar to the current list of "designated institutions" for Ontario-registered international dealers. The principal differences between the "designated institutions" list and the proposed "permitted client" exemption are:

  • the "designated institution" definition does not include any individual clients, while the "permitted client" definition includes an individual who beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds C$5 million, and includes a person or company that is entirely owned, legally and beneficially, by such an individual or individuals; and
  • a corporation that has shareholders' equity of a least C$100 million on a consolidated basis. (Note: This is a significant limitation as the threshold is C$5 million under the definition of "designated institutions"). 

Under the proposed international dealer exemption, non-Canadian dealers will be restricted to trading only in "foreign securities." Presently, a non-Canadian dealer may trade in both Canadian and non-Canadian securities on a dealer registration-exempt basis with an "accredited investor" resident in most provinces and territories, other than Ontario. The "foreign securities" restriction is presently applicable to registered international dealers in Ontario.

Exempt Market Dealer Registration

If a non-Canadian dealer wishes to trade with "accredited investors" in Canada, the dealer will need to register as an "exempt market dealer." An exempt market dealer registration will require a non-Canadian dealer to satisfy a number of Canadian requirements such as individual proficiency, registration of directors and officers, capital, insurance and designation of a compliance officer and senior business person. This registration is significantly more onerous than the current "international dealer" registration in Ontario.

Comment Period

The comment period on the Instrument is open until May 29, 2008.

Registration Reform Round Two: Key features for investment fund managers, foreign funds and private equity funds

Alix d'Anglejan-Chatillon, Jennifer Northcote and Kenneth G. Ottenbreit | Version française

On February 29, 2008, the Canadian Securities Administrators (CSA) published their revised proposals relating to national registration requirements for dealers, advisers and investment fund managers.  Over 260 comment letters were received on the original proposals (published in February of 2007). These proposals constitute an overhaul of registration requirements and registration exempt activities, and are intended to present a streamlined and harmonized approach to the regulation of investment activities across Canada. The revised proposals are open for comments until May 29, 2008.

The key features of the revised proposals with respect to Canadian investment fund managers, mutual fund dealers, foreign investment funds offered into Canada on a private placement basis and private equity funds include the following:

Registration of investment fund managers

  • Persons or companies which are "investment fund managers" (i.e., which are permitted to direct the business, operations and affairs of an investment fund) will be required to register and comply with prescribed "fit and proper" requirements, conduct rules and conflicts of interest standards.
  • The key elements of this new category of registration include: (a) a registration requirement for a person or company acting as an investment fund manager; (b) two new categories of individual registration requiring all registered investment fund managers to designate an individual as the ultimate designated person (UDP) and the chief compliance officer (CCO); (c) proficiency requirements for the CCO (but not the UDP); (d) insurance requirements; (e) a $100,000 minimum excess working capital requirement (for non-SRO members); and (f) conduct rules.
  • Under the "new business trigger" for registration (which will apply in most, but not all, provinces), additional dealer or adviser registrations will be required if the investment fund manager is also engaged in the business of trading or advising in securities as a business.  The CSA have expanded the guidance for the business trigger test and indicated that firms registered in multiple categories will have to comply with the most stringent "fit and proper" requirements and conduct rules.
  • The CSA have clarified that investment fund managers will be required to register only in the jurisdiction where the investment fund manager is located.
  • The Ontario Securities Commission (OSC) has clarified that investment fund managers which are registered or exempt from registration in Ontario will be required to pay capital market participation fees under OSC Rule 13-502 Fees.

Foreign investment funds

  • The new registration rule will introduce significant changes to the private placement rules on the basis of which foreign fund offerings have been effected in Canada.  The main change is the repeal, for the most part, of the dealer registration exemptions contained in National Instrument 45-106 Prospectus and Registration Exemptions, including the exemption for trades with "accredited investors" and the introduction of a universal dealer registration requirement based on the new business trigger for registration.
  • The first draft of 31-103 had given rise to considerable uncertainty with respect to the application of the dealer, adviser and investment fund manager registration requirements in cross-border fund offerings. In response to significant comments on this issue, the CSA have made a number of changes which, if adopted, should simplify the process of privately placing foreign fund securities to a new category of super-accredited investors called "permitted clients".  These permitted clients are a subset of the "accredited investor" category and include institutional and similar entities, as well as qualified high net worth individuals (net financial assets over C$5M), entities legally and beneficially owned by qualified individuals and qualified corporations (shareholders' equity over C$100M).
  • First, the revised proposals introduce key exemptions from the dealer and adviser registration requirements for qualified "international dealers" and "international advisers" engaging in certain limited trading and advisory activities with "permitted clients".
  • As a result of these exemptions, the securities of foreign investment funds could be sold into Canada either to a "permitted client" through a dealer registered in a foreign jurisdiction which relies on the international dealer registration exemption or through a locally registered dealer to any other category of accredited investor.  Certain other limited types of fund offerings which would not trigger the application of the dealer registration requirement under the new business trigger test could potentially be made directly to any Canadian-resident accredited investor.
  • Second, the CSA have effectively discarded the application of the "look through" principle historically applied by the OSC as a result of which the foreign portfolio manager of a non-resident investment fund which issues securities to Ontario-resident investors is deemed to be providing advice in Ontario and is therefore subject to the adviser registration requirement unless an exemption is available. However, unless the international dealer exemption is available, the offering of securities of non-resident funds in any province will generally have to be made through a locally registered dealer.
  • Third, the CSA have clarified that if an investment fund manager is located outside of Canada, there is no requirement for it to be registered as an investment fund manager in Canada, unless it is directing the management of an investment fund from inside Canada.

Private equity funds - venture capital

  • The application of the proposed registration rules with respect to private equity funds and a range of other funds which do not fall within the definition of "investment fund" for purposes of the securities rules is uncertain.  In response to substantial comments seeking greater clarity as to the specific application of the business trigger test, the CSA have issued additional guidance with respect to activities they characterize as "venture capital" investing.
  • In particular, the CSA have noted that the "expectations and reliance of investors" must be considered when applying the business trigger factors to venture capital.
  • The Companion Policy gives specific guidance in respect of registration requirements for general partners of limited partnerships, specifically in the portfolio manager context.  For example, if the purpose of the limited partnership is to invest in a trading portfolio of securities and the limited partners are relying on the general partner's expertise in selecting and transacting securities, the CSA would require that the general partner register as an adviser.
  • Conversely, the Companion Policy indicates that the adviser registration requirement will not necessarily be triggered in cases where, for example, a limited partnership is operating as a venture capital fund and the general partner's role is to select small private companies that the general partner will actively manage and develop.  The stated basis for the CSA's position in this context is that the purchase and sale of the securities of these companies is incidental to the general partner's activities on behalf of the limited partners.
  • The CSA have also clarified that M&A specialists advising parties to a transaction would not be required to register as advisers since the business purpose of these specialists is to effect corporate transactions and not to trade in securities.  The CSA have not specifically addressed the trading aspect of these activities but presumably the same analysis applies.

Dealer registration exemption for pooled funds sold to fully-managed accounts

  • The revised proposals include a dealer registration exemption for registered advisers or advisers relying on the "international adviser" exemption covering the purchase and sale of securities of pooled funds administered by the adviser for fully-managed accounts established and managed by the adviser.
  • The exemption is only available if the adviser gives written notice to the relevant regulator within 5 business days of the first use of the exemption and if the fully-managed account or the pooled fund is not created or used primarily to qualify for the exemption.

SRO relief

  • The revised proposals include broader relief from a number of "fit and proper" and conduct-related requirements for registrants that are members of an SRO, including the Investment Dealers Association of Canada (IDA) and the Mutual Fund Dealers Association of Canada (MFDA) or Quebec-registered mutual fund dealers which comply with the rules applicable to mutual fund dealers in Québec.

Mutual fund dealers

  • Following public consultations in 2007, the Autorité des marchés financiers of Québec (AMF) has indicated that Québec mutual fund dealers, scholarship plan dealers and investment contract dealers and their representatives which are currently subject to the Quebec Act respecting the distribution of financial products and services will become subject to securities laws, including 31-103.  They will continue to be supervised by the AMF and their representatives will continue to be required to be members of the Chambre de la securité financière.  They will not be required to become members of the MFDA.
  • The CSA have also clarified the ability of mutual fund dealers in certain jurisdictions (excluding Québec) to trade in securities of investment funds that are labour sponsored investment fund corporations or labour sponsored venture capital corporations and, in British Columbia, securities of scholarship plans or educational trusts.

Transition

The amendments to the original proposals now also include specific transition provisions.  Existing registrants will, in most cases, be deemed to be registered in the equivalent new category (and given six months to comply with new requirements, such as relationship disclosure and complaint handling). New registrants, such as investment fund managers, will have six months to apply for registration and to comply with most of the requirements of the new rules.

Sovereign Wealth Fund investment: What's next for Canada?

Curtis Cusinato, Jeffrey Singer and Sandra Walker  | Version française

As financial institutions and private equity firms focus on recovery from the subprime mortgage crisis, government investment vehicles known as Sovereign Wealth Funds (SWFs) are emerging as key players in global M&A. Quite apart from the spotlight cast on them by their recent (and heroic) intervention in the financial markets, including investments in Citigroup, Bear Stearns, Morgan Stanley and Merrill Lynch, SWFs are attracting widespread international attention because of their dramatic growth. No longer the almost exclusive preserve of the traditional oil exporters,1 they are being established in significant numbers in Asian export economies as well as in Russia and other emerging natural resources powers. According to one recent estimate, the holdings of SWFs worldwide may top US$12 trillion by 2015.2 Another important development is a shift in investment strategy away from lower-yielding bond investments towards equity investments and (most significantly) key strategic assets.

In light of this phenomenal growth, SWFs and other state-owned enterprises (SOEs) are coming under enhanced scrutiny from the governments of countries in which they invest. On February 27, 2008, the European Union became the latest jurisdiction to address SWF investments, issuing a communiqué in support of a common European approach to SWFs in advance of the upcoming Spring 2008 meetings of the European Council.3 This followed the announce¬ment of SWF investment review policies by Australia and Canada, whose highly developed resource-based economies are prime targets for SWFs. A recent issue of Stikeman Elliott's M&A Update reviewed the Government of Canada's new SOE guidelines ("the Guidelines" 4), summarizing the Government's concerns over the possible non-commercial orientation of some SOE/SWF investments and with respect to their adherence to Canadian standards of corporate governance and transparency.5

Sovereign Wealth Fund investment under Canada's new guidelines

It should be noted at the outset that certain types of investment may not be significantly affected by the Guidelines. First, the Guidelines do not apply to acquisitions that are not large enough to be reviewable under the Investment Canada Act,6 nor do they capture minority investments. For SWFs seeking to take smaller portfolio stakes in Canadian companies (e.g., less than one-third of the voting shares for non-cultural businesses), it will be "business as usual".7 Second, sectoral laws already restrict foreign investment in a number of critical sectors such as airlines,8 telecommunications,9 banking10 and publishing.11

Given the political sensitivity of foreign state investment, the Guidelines' biggest impact may be felt where SWFs and other SOEs make substantial investments in critical resource and infrastructure projects - targets of particular interest to such investors. In Canada, as in the U.S. and elsewhere, the political dynamics associated with such investments may well be complex and challenging. The Guidelines have sent a signal that the state status of the investor, not previously a consideration in the review of foreign investments under the Investment Canada Act, will result in close scrutiny. Government concerns over significant investments in key Canadian assets, exacerbated in many cases by a public hue and cry, may well compel the Government to establish demanding conditions for approval, a prospect that may be unpalatable to many SWFs.12 For example, the Guidelines indicate that the Government could require a state investor to list the acquiring company or the target company on a Canadian stock exchange and comply with Canadian standards of corporate governance (such as adding independent directors to its board).13 The Guidelines also do not preclude the possibility that the Government might scrutinize the SWF's record as an investor in other countries, including its home state, during the investment review process.14

SWF partnerships with Canadians

To allay Government and public concern over potential foreign state control of high profile Canadian businesses in key sectors, SWFs may consider structuring partnerships with Canadian pension funds, Canadian-controlled private equity firms or other Canadian pools of capital.

One approach would be for the SWF to take only a minority equity stake in the acquisition vehicle, with Canadian partners holding a majority, with the result that the acquisition vehicle would be regarded as Canadian. This type of structure would be similar to that used by Canadian pension funds or private equity in several large-scale acquisitions in sectors in which foreign ownership is restricted to a minority non-controlling position.

Still, there may be challenges with such partnerships. If Canadians own the majority of the equity in an acquisition vehicle and the SWF has only a minority holding, the SWF may balk at not having control in fact or at ceding significant power to its Canadian partners (e.g., majority of board members, operational control, etc.). Another complicating factor is the limited number of Canadian pension funds and other sources of capital in Canada that are of sufficient size to participate significantly in a major infrastructure or resource bid, which can make it difficult to "Canadianize" the investment vehicle. While Canadian pension funds and other institutional investors may be subject to statutory or other restrictions on their level of ownership or control of acquisition vehicles, a number of acquisition structures have been successfully employed in the past to mitigate the effects of these restrictions.

A second approach would be for the SWF to assemble a syndicate of Canadian and non-Canadian investors. If, for example, there are three investors (a foreign private equity player, an SWF and a Canadian) each with approximately the same share of the acquisition vehicle, the vehicle, while a non-Canadian under the Investment Canada Act, may not be considered to be an SOE under the Guidelines. A potential weakness with this strategy is that the Guidelines do not offer any bright line demarcation of when an acquisition vehicle is state-controlled. However, the SWF may be able to counter this difficulty by showing that it operates at arm's length from its home state and has investment objectives that relate solely to maximizing revenue. Even if the acquisition vehicle is characterized as state-owned and is therefore subject to the Guidelines, the fact that the SWF has an arm's length relationship with the home state and has commercial objectives would in any event likely reassure the Government that the SWF may be treated as similar to private capital.

A third option is for the SWF to acquire a control in fact position in the acquiring entity while at the same time cementing a partnership with Canadian investors that reassures the Government that despite being a foreign state-owned enterprise, the SWF is entering the market for commercial reasons rather than for political, national or other similar objectives. If the Canadian co-investor has negative control (i.e., the ability to veto certain fundamental actions by the SWF in relation to the acquisition vehicle), Government and public concerns that the acquiring entity would act contrary to Canadian interests might well be mollified.

A potential limitation on any of the above three strategies would arise if the SWF has different investment objectives than possible co-investors. For example, an SWF that is interested in acquiring control of strategic assets in Canada may be less concerned about traditional transactional issues such as purchase price, deal premiums, return on investment, liquidity alternatives or any agreement to give substantial undertakings to the Canadian Government, given its longer term investment horizon and strategic goals. This may be at odds with the objectives of Canadian or U.S. pension funds, private equity groups or other financial players which tend to look to traditional return on investment measures.

SWFs in Canada going forward

SWFs seeking to invest in large Canadian companies, particularly those that are viewed as icons in critical sectors of the Canadian economy, may be well advised to explore partnerships with Canadian private equity, pension funds or other Canadian pools of capital. Ultimately, the success of SWFs will depend not only the nature of the investment and the industry but on creative deal making that goes beyond traditional financial and economic issues to address political and other concerns.

The authors wish to thank their colleague Andrew Cunningham for his assistance.


1  Note that SWFs are not a new phenomenon, having been established as early as the 1950s in a number of oil-rich jurisdictions. The Alberta Heritage Savings Trust Fund, established in 1976, is a Canadian example.
2 Stephen Jen, "How Big Could Sovereign Wealth Funds Be by 2015?", Morgan Stanley Research, May 3, 2007.
3  "
A common European approach to Sovereign Wealth Funds" (Brussels: Commission of the European Communities, February 27, 2008).
4  "
Guidelines - Investment by state-owned enterprises - Net benefit assessment" (Ottawa: Industry Canada, December 7, 2007).
5  See Sandra Walker, "
New guidelines for Canadian investments by foreign state-owned enterprises", M&A Update (Stikeman Elliott LLP, February 2008). Note that national security is not the focus of the Guidelines. Indeed, it is currently anticipated that the Government will introduce an amendment to the Investment Canada Act to permit the review of foreign investments on national security grounds.
6  With the exception of investments in transportation, financial services, uranium production and cultural businesses (the "sensitive sectors"), the review threshold for direct acquisitions of Canadian businesses is set at a book value of assets of the target of CDN$295 million. For the sensitive sectors, the review threshold is set at CDN$5 million.
7 For example, Norway's Government Pension Fund - Global has invested for years in foreign equity by taking passive minority stakes in companies.br /> 8 For example, foreign ownership of shares of air service companies is limited to 25%. In addition, there is a "control in fact" test that scrutinizes the influence of parties that might be non-Canadian over the affairs of the company.
9 Telecommunications common carriers must be Canadian owned and controlled. Among other requirements, not less than 80% of the carrier's voting shares are beneficially owned by Canadians.
10 Any person seeking to acquire or hold more than 10% of any class of shares of a bank must obtain the prior consent of the Minister of Finance.
11  The Department of Canadian Heritage has established policies that prohibit the acquisition of Canadian controlled book publishing and film or video distribution businesses.
12  Prohibitions of proposed investments have not occurred to date in Canada, outside the cultural industries sector.
13 Note that on March 2, 2008, an official of the China Investment Corporation, a US$200 billion SWF, publicly affirmed its commitment to transparency and independence from government.
14  In California, legislation was recently introduced that would restrict pension funds Calpers and Calstrs from investing in (or in funds managed by) private equity firms that are wholly or partly owned by a SWF and fail to meet transparency and (with respect to its parent government) human rights tests. California Assembly Bill No. 1967, "
An act to amend Section 16642 of, and to add Section 7513.8 to, the Government Code, relating to investments."

CSA's proposed registration reform: what it means for investment fund managers

Proposed NI 31-103 - Registration Requirements requires investment fund managers to register and to comply with prescribed proficiency, capital and conduct standards.

Currently, investment fund managers that administer an investment fund but do not advise or trade are generally not required to be registered. However, the Canadian Securities Administrators (CSA) are proposing an investment fund manager registration that encompasses the managers of all public and private mutual funds and non-redeemable investment funds, labour-sponsored investment funds, scholarship plans, pooled funds and hedge funds.

The key elements of this new category of registration include: (a) a registration requirement for a person or company acting as an investment fund manager; (b) two new categories of individual registration requiring all registered firms to designate an individual as the ultimate designated person (UDP) and the chief compliance officer (CCO); (c) proficiency requirements for the CCO (but not the UDP) of an investment fund manager; (d) insurance requirements; (e) a $100,000 minimum excess working capital requirement (for non-SRO members); and (f) conduct rules for investment fund managers.

Registration for investment fund managers

The requirement to register an as investment fund manager is contemplated by the recently released proposed National Instrument 31-103 - Registration Requirements (the Proposed Registration Rule) and accompanying companion policy (Companion Policy), which will be implemented by a change to the Securities Act in each jurisdiction. All persons or companies who are "investment fund managers" will be required to register and to comply with prescribed fit and proper requirements, conduct rules and conflicts of interest standards.

The CSA intend that firms carrying on more than one type of activity will be required to register and comply with the requirements of multiple categories, as applicable. Although the Proposed Registration Rule is unclear on the definition of investment fund manager (further guidance is anticipated), the Companion Policy indicates that the management of an investment fund includes "administering" the fund, which may include information gathering, performance reporting and handling client assets, but does not include acting as portfolio manager for the fund.

While neither private equity nor venture capital funds are expressly addressed in the Proposed Registration Rule, the Companion Policy gives some guidance in respect of registration requirements for general partners, specifically in the portfolio manager context. For example, if the general partner is making investment decisions for the limited partners who rely primarily on the general partner's expertise in selecting investments in securities, that could trigger a requirement to register as a portfolio manager. Conversely, the Companion Policy indicates that a registration requirement will not necessarily be triggered in cases where, for example, a limited partnership is operating as a venture capital fund and the general partner's role is to select companies in which it will participate in active management and development (with the rationale that the purchase and eventual sale of these securities is incidental to the operational business activity of the limited partnership).

In their notice to the Proposed Registration Rule, the CSA indicate that investment fund managers must be registered in the Canadian jurisdiction in which the fund is "located". Given the international investment fund manager exemption (discussed below), it is unclear whether a presence in Canada is required in order to trigger registration requirements, and no guidance is given in relation to determining the location or the process of registration generally. Registration as an investment fund manager does not have to be renewed annually, and will remain in effect until suspended or terminated by certain "triggering events", including non-payment of annual fees and failure to comply with on-going fit and proper and conduct requirements.

Additional new individual categories of registration - UDPs and CCOs

The Proposed Registration Rule introduces two new individual categories of registration for all registrants including investment fund managers, namely the UDP and the CCO.

The UDP's role is to ensure that the registrant complies with applicable securities regulations and that written compliance policies and procedures are developed and implemented. The designated UDP must be the CEO of the registered firm, a senior officer responsible for the division within the firm which is carrying on investment fund activity, or someone with a similar function, but does not necessarily need to be someone who is involved in the day-to-day compliance management of the group. No proficiency requirements are specified for the UDP function.

The CCO is responsible for the management and supervision of the day-to-day monitoring of compliance with the registrant's compliance system. Accordingly, the CCO (who must be an officer or partner of the registered firm, or, if applicable, the sole proprietor), will be subject to the same proficiency requirements as required for the CCO of a portfolio manager (discussed below).

While the CSA would prefer that the UDP and CCO roles be performed by different individuals, they do recognize that this may not always be practical, particularly for smaller investment fund managers and sole proprietors. Depending on the size and structure of the investment fund manager, the CSA would permit the UDP and CCO function to be performed by the same individual (who may also be required to be registered in the dealing or advising categories), provided they meet the requirements for all designations and are registered separately for each.

Fit and proper, conduct and conflicts of interest requirements

Registered investment fund managers must comply with many of the fit and proper requirements, conduct rules and conflicts of interest provisions set out in the Proposed Registration Rule.

Exemptions for Members of Self-Regulatory Organizations (SRO)

Certain requirements in the Proposed Registration Rule (for example, the proficiency and solvency requirements) will not apply to investment fund managers who are members of the IDA or an MFD SRO.

Fit and proper requirements

The cornerstones of the registration fit and proper requirements are proficiency, solvency and integrity. Non-compliance may result in the imposition of terms and conditions, or revocation or suspension of registration.

  • Proficiency: There are no proficiency requirements for a UDP, but a CCO of an investment fund manager must comply with the same proficiency requirements as provided for the CCO of a portfolio manager. Accordingly, the CCO of an investment fund manager must:

    • have previously been registered as an advising representative of a portfolio manager,
       
    • have:
      • obtained professional designation as a lawyer or chartered accountant in Canada and be in good standing;
      • passed the Canadian Securities Exam and the Partners, Directors and Senior Officers Exam; and
      • either been employed for three years as a registered dealer or adviser or provided professional services to the securities industry for three consecutive years and been employed by a registered dealer or registered adviser for 12 consecutive months; or
         
    • have:
      • passed the Canadian Securities Exam and the Partners, Directors and Senior Officers Exam; and
      • either been employed for five consecutive years by a registered dealer or adviser (including three years under the supervision of the CCO), or been employed for five consecutive years by a regulated financial intermediary and employed by a registered dealer or registered adviser for 12 consecutive months.

         
    • Capital requirements: All non-SRO registered investment fund managers will be required to have a minimum excess working capital of not less than $100,000 (considerably more than the minimum capital requirement for non-SRO advisers and dealers). Excess working capital must be calculated as at the end of each month by completing Form 31-103F1 - Calculation of excess working capital within 20 days following the end of the month, and the regulator must be notified if the excess working capital is ever calculated to be less than zero.
    • Insurance: Investment fund managers will be required to maintain a financial institution bond in the greater of the following amounts: (a) the amount which is the lesser of 1% of the assets under management or $25,000,000; (b) $200,000, and (c) any other amount determined necessary by the directors of the investment fund manager. As a minimum, insurance must be maintained by way of a financial institution bond with a double aggregate limit or a provision for full reinstatement of coverage, and must include the clauses specified in Appendix A of the Proposed Registration Rule (fidelity, on premises, in transit, forgery, alterations, and securities clauses). The regulator must be notified in writing of any change in, claim made under, or cancellation of the financial institution bond.
    • Financial records: Non-SRO registered investment fund managers will be required to appoint an auditor and to deliver annual financial statements with the audit report within 90 days of year end and quarterly financial statement within 30 days following the completion of the first, second and third fiscal quarters. All financial statements are to be prepared in accordance with GAAP but on an unconsolidated basis, and a special form of audit report for regulatory purposes (known as a section 5600 report) is required. The annual and quarterly financial statements must each be accompanied by a completed Form 31-103F1.
    • NAV adjustments: The quarterly and annual financial statements must be accompanied by a description of any net asset value adjustment made during the relevant period, including a description of the cause of the adjustment, its dollar amount, and the effect of the adjustment on NAV per unit or share and any corrections made to purchase and sale transactions affecting either the investment fund or security holders of the investment fund.

Conduct rules

The Proposed Registration Rule and Companion Policy contain detailed and technical conduct requirements for all registrants, not all of which apply to investment fund managers. The conduct rules which do apply to investment fund managers include:

  • Client assets: Investment fund managers will be required to hold securities or other client property in trust separately from their own property.
  • Record keeping: Investment fund managers will be required to maintain records to accurately record their business activities, financial affairs and client transactions, as well as to demonstrate regulatory compliance. Records must be safeguarded and be kept in durable form. Activity records (which include, inter alia, trade confirmation statements, records of dividends and interest paid and communications between the investment fund manager and the client) must be kept for seven years from the date of the activity.
  • Compliance: Investment fund managers will be required to establish, maintain and enforce appropriate systems to achieve compliance with securities legislation and to manage the risks associated with conducting its business in conformity with prudent business practices. The compliance measures must be documented in the form of written policies and procedures, and the CCO must report directly to the board of directors on securities compliance at least annually.
  • Complaint handling: Investment fund managers must establish and implement complaint handling procedures, including procedures for recording and investigating complaints and policies for the resolution of disputes concerning the firm's products or services. In addition, non-SRO registered investment fund managers will be required to participate in a dispute resolution service which mirrors similar requirements of the SROs.
  • New reporting requirements: Investment fund managers must submit an annual report within 2 months of year end to the securities regulators detailing their complaints handling policy, and the number and nature of complaints received.

Conflicts of interest

The Proposed Registration Rule consolidates and streamlines conflict of interest provisions, requiring investment fund managers to implement procedures and internal structures for managing and disclosing conflicts of interest in a fair, equitable and transparent manner. Conflicts of interest must be identified and managed fairly and in the best interests of clients, and conflict of interest disclosure is prescribed in certain cases, including with respect to trades and offerings involving securities of related entities (research reports involving such securities are severely circumscribed).

Exemptions from registration

The Proposed Registration Rule contains limited exemptions from the registration requirement for, among others, "international investment fund managers", who will be exempt if the securities of the fund are:

  • primarily offered outside of Canada;
  • only distributed in Canada through a registered dealer; and
  • distributed in Canada in reliance upon an exemption from the prospectus requirement.

An "international investment fund manager" is an investment fund manager that has no establishment in Canada or officers, employees or agents resident in Canada, and engages in the business of a portfolio manager in the jurisdiction in which its head office or principal place of business is located.

There is a similar exemption from the requirement to register as an adviser for an "international portfolio manager" advising an investment fund. It is unclear whether the inclusion of that international portfolio manager registration exemption when advising an investment fund is a sign that the CSA are moving towards the approach currently taken by Ontario with the "look through" analysis reflected in OSC Rule 35-502 - Non-Resident Advisers (under which portfolio managers of an investment fund sold to investors in Ontario are treated as advisers who must be registered as such in Ontario unless an exemption is available).

Fees

The Proposed Registration Rule does not impose filing or participation fees. The only reference to fees is in the context of the suspension or revocation of registration (non-payment of fees is one of the triggering events for a revocation or termination of registration). Currently, Ontario is the only CSA jurisdiction which requires market participants (including currently unregistered investment fund managers) to pay an annual capital markets participation fee. It remains to be seen whether and to what extent other CSA jurisdictions will follow Ontario's lead, and how the interplay between fees and registration is regulated.

Implementation and transition

The Proposed Registration Rule and Companion Policy were published by the CSA on February 23, 2007, and remain open for comment until June 20, 2007. The CSA have indicated that they intend to move quickly in finalizing and implementing the Proposed Registration Rule, and this is anticipated sometime in 2008. Implementation of the Proposed Registration Rule will require amendments to provincial securities laws and regulations, proposed drafts for which have not yet been published in any jurisdiction with the exception of Alberta. A transition timetable is also yet to be published.

How do I learn more?

 If you wish to receive other updates in the series or further information, please contact your Stikeman Elliott representative or the authors, Jennifer Northcote, Darin Renton, Simon Romano, Kathleen Ward and Ramandeep Grewal.

National Registration Reform Proposal - Impact on non-Canadian investment funds

On February 20, 2007, the Canadian Securities Administrators (CSA) published for comment Proposed National Instrument 31-103 - Registration Requirements (Proposed Registration Rule). The comment period will expire on June 20, 2007.

The Proposed Registration Rule is one phase of the CSA Registration Reform Project which is intended to harmonize and streamline registration requirements across Canada. It represents a major restructuring of the Canadian dealer, adviser and investment fund manager registration rules, and has implications for Canadian and non-Canadian dealers, advisers and investment fund managers doing business on a registered or exempt basis in any province or territory of Canada.

Proposed changes to the registration and exemption regime

The primary effects of the Proposed Registration Rule on non-Canadian investment funds are:

  1. repeal of the dealer registration exemptions contained in National Instrument 45-106 Prospectus and Registration Exemptions ("NI 45-106"), including the exemption for trades with an "accredited investor";
  2. continuation of the requirement for portfolio managers to register in Canada;
  3. introduction of a requirement for "investment fund managers" to register in Canada;
  4. introduction of a national exemption from the adviser registration requirement for "international portfolio managers" provided that securities of the investment fund are distributed through a registrant; and
  5. introduction of a national exemption from the investment fund manager registration requirement for "international investment fund managers" provided that securities of the investment fund are distributed through a registrant.

Current dealer and adviser registration and exemption regime

Except in Ontario (and the Yukon Territory and Newfoundland and Labrador), provincial and territorial securities laws generally permit a non-Canadian investment fund to sell its own securities to "accredited investors" on a dealer registration and prospectus exempt basis subject to certain disclosure requirements and post-distribution filings. Such exempt distributions are common private placement transactions in Canada. In Ontario, the dealer registration exemption, but not the prospectus exemption, has been removed for "market intermediaries".

The Ontario Securities Commission (OSC) considers an adviser to be acting as an adviser in Ontario if it, directly or through a third party, acts as an adviser for an investment fund that distributes its securities in Ontario, notwithstanding that the advice to the fund may be given to, and received by, the fund outside of Ontario.

As a result, portfolio advisers to investment funds that distribute securities in Ontario must either be registered as advisers in Ontario or rely on an adviser registration exemption. In Ontario, a common practice is for non-resident investment funds to rely upon an adviser registration exemption if the securities of the investment fund are (i) primarily offered outside of Canada, (ii) only distributed in Ontario through a registrant, and (iii) distributed in Ontario in reliance upon an exemption from the prospectus requirements (e.g., "accredited investors").

The practical effect of the Ontario rules is that the sale of investment fund securities in Ontario is typically intermediated by an Ontario-registered dealer, subject to compliance with certain disclosure and post-distribution filing requirements.

Requirement to register as a portfolio manager and investment fund manager

The Proposed Registration Rule makes a distinction between those that are in the business of advising others as to the investing in of securities (i.e., a portfolio manager) and those that are in the business of managing and administering an investment fund (i.e., an investment fund manager). Persons or companies that are in the business of managing an investment fund will be required to register as an investment fund manager.

The Proposed Registration Rule requires that portfolio managers to investment funds and investment fund managers be registered in Canada or comply with the limited international portfolio manager and international investment fund manager exemptions. The Proposed Registration Rule effectively imposes a registration requirement on portfolio managers and investment fund managers where investment fund securities are distributed in any Canadian jurisdiction. The Proposed Registration Rule is silent on what specifically triggers the registration requirement for non-Canadian investment fund service providers.

The British Columbia Securities Commission is considering not adopting the registration requirements for persons who are in the business of dealing in the exempt market. It is unclear whether this will affect the registration requirements for portfolio managers and investment fund managers.

In cases where a company is both a portfolio manager and an investment fund manager, registration will be required in both categories under the Proposed Registration Rule. The registration requirements include application of various "Fit and Proper" requirements such as the requirement to have an Ultimate Designated Person, a Chief Compliance Officer and registered personnel that meet certain proficiency standards, capital and insurance requirements, financial statement filing obligations, and other requirements.

Proposed international portfolio manager and international investment fund manager exemptions

The Proposed Registration Rule contains exemptions from the registration requirements for "international portfolio managers" and "international investment fund managers".

International portfolio managers and international investment fund managers to an investment fund will be exempt from the registration requirements if:

  1. the securities of the fund are primarily offered outside of Canada;
  2. the securities of the fund are only distributed in Canada through a registrant; and
  3. the securities of the fund are distributed in Canada in reliance upon an exemption from the prospectus requirement.

In order to rely on the exemption, an international portfolio manager must also satisfy certain client notification and disclosure requirements.

An "international portfolio manager" is a portfolio manager that has no establishment in Canada or officers, employees or agents resident in Canada, and engages in the business of a portfolio manager in the jurisdiction in which its head office or principal place of business is located.

An "international investment fund manager" is an investment fund manager that has no establishment in Canada or officers, employees or agents resident in Canada, and engages in the business of an investment fund manager in the jurisdiction in which its head office or principal place of business is located.

Significantly, under these definitions, "international portfolio managers" and "international investment fund managers" need not be registered in their home jurisdictions. Such entities must simply engage in the business of a portfolio manager or investment fund manager, as the case may be.

Notably, investment funds cannot be distributed through a non-resident dealer relying on the proposed "international dealer exemption" contained in the Proposed Registration Rule. Consequently, investment funds must generally be distributed through an "exempt market dealer", a proposed new category of dealer registration, or a fully registered Canadian investment dealer.

Transition

The Proposed Registration Rule does not set out any grandfathering or other transitional relief for non-Canadian investment funds that have issued securities to Canadian investors prior to the coming into force of the Proposed Registration Rule. For funds with limited redemption features, this may be an issue. It is also unclear how these requirements will apply to the service providers to non-Canadian investment funds that placed securities in Canada before the Proposed Registration Rule becomes effective.

CSA to overhaul adviser, dealer and investment fund manager registration

Kathleen Ward, Alix d'Anglejan-Chatillon, Ramandeep Grewal, Jennifer Northcote, Darin Renton and Simon Romano

The Canadian Securities Administrators (CSA) have now released for comment the much anticipated proposed NI 31-103 - Registration Requirements (the Proposed Registration Rule), along with the accompanying companion policy (the Companion Policy) and forms. The Proposed Registration Rule represents a major overhaul of the current registration regime by moving from a "trade trigger" to a "business trigger" to require registration for those not only advising (as is currently the case) but also dealing in securities and by imposing a new registration requirement for investment fund managers.

New registration regime

The Proposed Registration Rule represents one piece of what is proposed to be a national, harmonized and simplified registration regime. The full regime is proposed to be brought into force through consequential amendments to securities legislation and related instruments, which will work in conjunction with the National Registration System and implementation of core client relationship principles through SRO by-laws (which are yet to be proposed).

In Ontario, for example, it is proposed that the Securities Act (Ontario) will be amended to require registration by anyone who is in the business of acting as a dealer or representative of a dealer, or who is an adviser or representative of an adviser or an investment fund manager. While the legislation will determine who needs to be registered, the Proposed Registration Rule will set out the categories of registration, for both firms and individuals, and the related requirements for these categories, including "fit and proper" requirements, conduct rules for dealers and advisers and obligations regarding conflicts of interest. Exemptions from the requirement to register as a dealer, including the exemption for trades with accredited investors, will be eliminated. While the text of the Proposed Registration Rule and related Companion Policy has been published for comment (summarized below), the detailed legislative amendments required to implement this regime have not yet been provided.

Meaning of "in the business"

The CSA propose certain factors to be considered in determining whether an activity is conducted as a business. These include, inter alia: undertaking an activity with repetition or regularity; being or expecting to be remunerated or compensated for undertaking the activity; soliciting others in connection with the activity; and holding oneself out as being in the business of conducting the activity.

Moving to this type of "business trigger" for dealers means dealer registration exemptions relating to specific types of trades or trades to specific types of investors will be eliminated (for example, the dealer registration exemptions contained in National Instrument 45-106 - Registration and Prospectus Exemptions, including the accredited investor exemption). These will be replaced by registration requirements for those "in the business of" dealing. While most security issuers themselves would not be "in the business" of dealing in securities (and therefore will not require registration or a registration exemption), the Companion Policy clarifies that an issuer that creates a secondary market in its securities or is a market maker for its own securities would likely be considered to be "in the business of" dealing in securities. Similarly, the Companion Policy states that, in most instances, the CSA would not consider a person whose main or sole activity is dealing for their own account to be in the business of dealing in securities.

Categories of registration

The Proposed Registration Rule contains five basic categories of dealer registration:

    1. Investment dealer

    2. Mutual fund dealer

    3. Scholarship plan dealer

    4. Exempt market dealer

    5. Restricted dealer

The exempt market dealer category is similar to the current "limited market dealer" category in Ontario and Newfoundland and Labrador, although the fit and proper requirements are more onerous than those applicable to limited market dealers. Persons registered as exempt market dealers would be permitted to deal only in securities being distributed under a prospectus exemption or to persons or companies to whom a security may be distributed under a prospectus exemption (for example, trading in prospectus qualified securities with accredited investors). British Columbia is considering not adopting the exempt market dealer category based on concerns that imposing registration requirements on those dealing in the exempt market will negatively impact venture capital business. Other categories of dealer in the various provinces would be eliminated.

The Proposed Registration Rule also contemplates two categories of adviser registration, namely, portfolio manager and restricted portfolio manager, as well as certain registration exemptions, including exemptions for international dealers and advisers. For an overview of the impact on international dealers and advisers, Stikeman Elliott has published a related Canadian Securities Law Update (February 2007).

Registration for investment fund managers

One of the more significant changes included in the new regime is the proposal to impose a registration requirement for managers of investment funds (which includes domestic, foreign, reporting and non-reporting issuers, but does not include private investment clubs). Investment fund managers will not only be required to register, but will also be subject to registration related obligations imposed under the Proposed Registration Rule, including solvency, proficiency and others (discussed below). The CSA's rationale for imposing fund manager registration is to allow regulators to directly regulate fund managers, impose requirements on fund managers relating to resources and supervision of out-sourced activities, and impose a framework for managing conflicts. Managing an investment fund is considered to include administering the fund but not acting as portfolio manager for the fund.

Individual registration categories

The Proposed Registration Rule also sets out two new categories of individual registration by requiring all registered firms to designate an individual as the ultimate designated person (UDP) and the chief compliance officers (CCO). The UDP is proposed to be the person in charge of the registrant firm or the division in the firm that carries on the activity requiring registration, and the CCO is proposed to be the person responsible for the day-to-day monitoring of compliance policies and procedures. Of importance to smaller registrants, the CSA also clarify that these functions can be carried out by the same individual.

Considerations for private equity and venture capital

While the Proposed Registration Rule does not expressly address private equity or venture capital funds, some guidance is offered in the Companion Policy in respect of registration requirements for general partners. Here the CSA state that whether the general partner will be in the business of providing advisory services and so required to register as an adviser will depend upon the business purpose of the limited partnership and the services the limited partners expect the general partner to provide.

The CSA state in the Companion Policy that if the general partner of a limited partnership selects investments where it will be involved in the management and development of those investments, the CSA would not consider the general partner's activities to be portfolio management activities requiring registration. This is in contrast to the situation where the purpose of the limited partnership is simply to invest in exempt securities relying on the expertise of the general partner. In the CSA's view, as the general partner does not bring "special expertise" to the underlying investments, it would be required to be registered as a portfolio manager. The CSA also state that they would not consider a firm that provides merger and acquisition advisory services without participating in the distribution of securities to be in the business of dealing in securities.

Referral arrangements

Specific requirements and disclosure obligations for referral arrangements pursuant to which a registrant pays or receives any compensation for the referral of a client are included in the Proposed Registration Rule.

Further requirements and rules

The Proposed Registration Rule also contains rules relating to proficiency, solvency and financial records for registrants (fit and proper requirements), detailed and technical conduct requirements (governing matters such as account opening and know-your-client, relationship disclosure and record-keeping), disclosure and compliance requirements relating to conflicts of interest and provisions governing suspension and revocation of registration. Details on these and other matters governed by the Proposed Registration Rule will be provided in our forthcoming updates.

Comment period

The Proposed Registration Rule is open for comments until June 20, 2007. Implementation is expected to stretch well into 2008 as the CSA have yet to provide any specifics on implementation dates or transition matters.

New independent oversight regime adopted for investment funds

NI 81-107 aims at improving fund governance by requiring investment funds to establish Independent Review Committees.

Jennifer Northcote, Kathleen Ward and Simon Romano

The Canadian Securities Administrators (CSA) have finalised NI 81-107 - Independent Review Committee (IRC) for Investment Funds (the Instrument), the first proposed version of which was released in January 2004. It was revised and subsequently republished for comment in May, 2005. Although this final version of the Instrument does not differ substantively from the May 2005 version, which was reported in our Funds Update of August 2005, it does address and clarify several issues that emerged during the comment period.

The Instrument and related amendments

The Instrument requires every investment fund that is a reporting issuer to have a fully independent body (the Independent Review Committee, or IRC) which is responsible for overseeing decisions that pose or have the potential to pose a conflict of interest. The Instrument also sets out a standard of care for investment fund managers with a view to ensuring that the interests of the investment fund are at the forefront when a fund manager is faced with a conflict of interest.

The Instrument applies to all public mutual funds, labour-sponsored or venture-capital funds, scholarship plans, and closed-end funds listed for trading on a stock exchange or quoted on an OTC market, regardless of size. It does not apply to pooled funds that sell securities to the public on a private-placement basis only, nor does it apply to funds that invest for the purpose of exercising control of, or being actively involved in, the management of issuers.

The Instrument will have far-reaching effects on the investment fund industry, with several consequential amendments also contemplated for various other instruments, including NI 81-101 - Mutual Fund Prospectus Disclosure, NI 81-102 - Mutual Funds, and NI 81-106 - Investment Fund Continuous Disclosure. Existing conflict of interest and self-dealing prohibitions in securities legislation will continue to apply, subject to exemptions in NI 81-107 and NI 81-102 allowing a manager to proceed with certain transactions that have received IRC approval under the Instrument.

Conflict of interest matters

The fund manager is expected to refer all matters in which a conflict of interest arises or is perceived to arise to the IRC in accordance with policies and procedures determined by the manager. This is consistent with the manager's overriding duty to act honestly and in good faith, and in the best interests of the investment fund.

A "conflict of interest" is a matter in respect of which a "reasonable person would consider the manager or an entity related to the manager to have an interest that may conflict with the manager's ability to act in good faith and in the best interests of the investment fund.". According to the Commentary to the Instrument (the Commentary), this includes inter-fund trades, transactions in securities of related issuers and purchases of securities underwritten by related underwriters, and extends to any proposed course of action that a fund, a manager or an entity related to the manager is restricted or prohibited from proceeding with by a conflict of interest or self-dealing provision contained in securities legislation.

An "entity related to the manager" includes agents of the manager and extends to the third-party portfolio managers or advisers, sub-advisers of a fund, as well as persons or companies who can "materially affect" the management and policy of the manager. Portfolio managers' decisions made on behalf of the fund that may affect the manager's ability to make decisions in the best interests of the fund are caught, but conflicts of interest at the service-provider level generally do not trigger regulation by the Instrument. Examples of what might be captured in this context include portfolio management processes allocating investments among a family of investment funds, and certain trading practices such as negotiating soft dollar arrangements.

The Instrument requires managers to create written policies and procedures to be followed when they are confronted with an actual or perceived conflict of interest. Such policies must also set out the applicable internal process for referring matters to the IRC for review or approval. Managers of more than one investment fund may establish blanket policies and procedures for all, or separate ones for each. Records of any activity subject to the review of the IRC must be maintained, and any such matters submitted to the IRC must be accompanied by information sufficient for the IRC to properly carry out its functions. In addition to implementing their own policies and procedures, managers are also expected to make reasonable inquiries about the policies and procedures implemented by their portfolio managers and advisers in respect of possible conflicts.

Certain conflict of interest matters must be approved by the IRC before the manager may proceed: for example, inter-fund trades, transactions in securities of a related issuer, or an investment in a class of securities of an issuer underwritten by an entity related to the manager. All other conflict of interest matters, though not subject to formal approval, must be submitted to the IRC for review and a recommendation as to whether the proposed action achieves a fair and reasonable result for the investment fund. The Instrument requires the manager to at least consider the IRC's recommendation in relation to these types of conflicts. Although IRC approvals or recommendations are generally provided on a case-by-case basis, a manager can act on standing instructions permitting it to engage in a particular conflict of interest action on a continuing basis on terms and conditions imposed by the IRC.

Unfortunately, the CSA did not see fit to impose a materiality or significance threshold in connection with the fund manager's obligation to refer conflict of interest matters to the IRC, with the Instrument providing that all conflicts be referred to the IRC for review or approval, as the case may be. That having been said, the definition of "conflict of interest matter" imposes a "reasonableness" standard which, according to the Commentary, denotes an exclusion of inconsequential matters. In determining what conflict transactions need to be reviewed by the IRC, managers are directed to follow industry best practices, which will emerge over time.

Appointment and composition of the IRC

The manager may appoint one IRC for all of its funds, or for any group of funds that it manages. Managers of investment funds may also share an IRC with other investment fund managers. This will very likely result in the emergence of a cottage industry of third-party IRC service providers.

The CSA expect the size of an IRC to be consistent with its workload, the minimum size being three members, all of whom must be "independent." A member is "independent" if he or she has no material relationship with the manager, the investment fund or an entity related to the manager. The Commentary sets out examples of individuals who would and would not qualify: for example, a person who is or has recently been an employee or executive officer of the manager (or is related to a recent former employee or executive officer) is unlikely to qualify; a member of the board of directors of a manager (whether independent or not) is also unlikely to meet the "independent" standard required for membership of an IRC (although a former independent member might). In certain circumstances, an independent member of the board of an investment fund may be considered "independent." For investment managers who have and wish to retain independent board members, the requirement to appoint a separate, independent IRC may seem duplicative.

The Instrument requires the manager of the fund to appoint the fund's first IRC. Subsequent appointments are in the sole domain of the IRC, which has the power to appoint new members or reappoint existing members to fill vacancies. Members of the IRC can be removed from office either by a majority of the IRC or by a majority of the securityholders of the investment fund voting at a special meeting convened for that purpose. In filling a vacancy or reappointing a member, the IRC is required to consider the fund manager's recommendations. To promote continuity and independence, a member of the IRC may serve for terms ranging from a minimum of one to a maximum of three years (the CSA recommends staggered terms of office). Consecutive terms may be served, but these may not exceed six years unless agreed to by the manager.

Liability and Indemnification of IRC members

The Instrument imposes a duty on the IRC to "act honestly and in good faith, with a view to the best interests of the investment fund." To assuage concerns about potential liability of IRC members, the CSA have taken steps to clearly define the functions, duties and obligations of the IRC (emphasizing its very specific and limited role), with a duty of care owed to the investment fund only. Further, the Commentary notes that the IRC is generally only required to consider matters referred to it by the manager. The CSA have concluded that exposure to liability should be commensurate with the narrow mandate of the IRC to review and make recommendations on conflicts of interest, and that any defences available generally to corporate directors should also be available to IRC members. The investment fund is required to indemnify IRC members for costs and expenses associated with the defence of an action, provided there has been no fault or omission on the part of the IRC member, who must also have acted in good faith, and, in the case of actions enforced by a monetary penalty, in the reasonable belief that his or her conduct was lawful. In addition, the Instrument permits the fund and manager to indemnify or purchase insurance coverage for IRC members even if they are not absolved from fault or omission, subject to the same good faith conditions as apply in respect of the mandatory indemnity cover. The CSA expect any such coverage to be on reasonable commercial terms.

The IRC's written charter

The IRC is required to adopt a written charter setting out its mandate, responsibilities and functions. Funds within a family are not required (but are permitted) to have separate charters. Although the Instrument permits the IRC broad discretion to tailor its written charter to its own particular circumstances, the CSA do indicate that they expect the written charter to include policies and procedures to be followed when reviewing conflict of interest matters, criteria regarding compensation and expenses, and policies relating to ownership by IRC members of securities of the investment fund, manager, or company that provides services to the investment fund. The Instrument requires the IRC to consider the manager's recommendations in formalizing its charter, which may include additional functions to those prescribed by the Instrument and securities legislation (bearing in mind that any such additional functions are not regulated by the Instrument).

Compensation, fees and expenses

The fund is obliged to pay all reasonable costs and expenses incurred by the IRC from the assets of the fund (which may, in turn, be reimbursed to the fund by the manager). The manager is required to set the initial compensation of the IRC. Thereafter, the Instrument grants the IRC sole authority to set its own reasonable compensation going forward; however, it must take into account the manager's recommendations in doing so. If the IRC fails to follow the manager's recommendation on the amount and type of compensation, this must be disclosed in the annual report to the securityholders, giving reasons and describing the process and criteria it applied.

Reporting requirements of the IRC

The IRC is required to report on the adequacy and effectiveness of the policies and procedures on conflicts matters on an annual basis. Focusing on both substantive and procedural aspects, this assessment must include a review of the effectiveness and adequacy of the manager's conflicts policies and procedures, and a consideration of its own effectiveness (including an assessment of the independence and compensation of its members). Written results of the assessment must be delivered to the manager, along with recommendations on any changes that should be made to the manager's policies and procedures.

In addition, the IRC must prepare an annual report to securityholders describing the IRC and its activities during the year. If the IRC is of the view that an action by the manager is not fair and reasonable, or if the manager proceeds with an action in relation to which the IRC did not give a positive recommendation, this must be reported. The annual report to securityholders must be filed with the securities regulatory authorities no later than the date on which the investment fund files its annual financial statements, and must be made available and prominently displayed on the investment fund or manager's website.

The Instrument also imposes a positive duty on the IRC to report to the securities regulators any instances where a manager has failed to comply with a condition imposed by securities law or the IRC in respect of a conflicts matter requiring IRC approval. The CSA has indicated that it will treat any such failure to comply as a breach of securities legislation, exposing the manager to regulatory action, which could include unwinding the transaction. The IRC also has authority (but is not obliged) to communicate directly with the securities regulators as and when it sees fit on any other matter.

Implementation and Transition

The Instrument has been or is expected to be adopted as a rule in British Columbia, Alberta, Manitoba, Newfoundland and Labrador, Nova Scotia, Ontario and New Brunswick. It will be adopted as a commission regulation in Saskatchewan and as a regulation in Quebec. It is expected to come into force on November 1, 2006. A one-year transition period is contemplated so that, although managers must appoint an initial IRC for a fund by May 1, 2007, the Instrument will not apply to the fund and manager until November 1, 2007. A fund manager can, however, elect to have the Instrument apply earlier by giving notice to the fund's principal regulator and thereby take advantage of the exemptive relief available for certain conflict of interest matters.

How do I learn more?

We have also prepared a more detailed NI 81-107 publication entitled "Answers to Questions you may be asking about NI 81-107" which is available on request. Further, if you wish to be added to any of our special interest mailing lists please contact us at info@stikeman.com

NI 45-106 Would Consolidate and Harmonize Private Placement Prospectus and Registration Exemptions Across Canada

Members of the Canadian Securities Administrators (CSA) recently published for comment proposed National Instrument 45-106 - Prospectus and Registration Exemptions (the Instrument).

Substance and Purpose

The Instrument is intended to:

  • consolidate and harmonize the prospectus and registration exemptions contained in various provincial statutes and national, multilateral and local instruments, and the disclosure and filing requirements associated with those exemptions, into a single national instrument;

  • repeal or make consequential amendments to a number of national and multilateral instruments;

  • modify the existing exemptions to make them more concise and consistent; and

  • create new exemptions for relatively routine exemptive relief applications.

Under the current regime, most jurisdictions have a similar, but not identical, set of exemptions. This means that market participants wishing to effect a multi-jurisdictional exempt distribution in Canada must comply with all the various exempt distribution regimes of the relevant jurisdictions. The Instrument, however, will generally enable market participants to view the landscape of exemptions, with the exception of those jurisdictions, including Ontario, that will retain certain local exemptions. Ontario local exemptions will be consolidated in the revised OSC Rule 45-501.

Summary of the Proposed Instrument

The substance of the proposed Instrument can be summarized as follows:

Definitions

  • "Founder" will be defined based on MI 45-103. The term "founder" will replace the concept of "promoter," which is currently contained in the securities legislation of most jurisdictions. A designation as a "founder" requires active involvement in the business of the issuer at the time of the trade and not simply the ownership of a certain percentage of an issuer's securities.

  • "Control" will have two different interpretations in the Instrument. The exemption for trades to employees, executive officers, directors and consultants will contain a broader concept of "control" than for the rest of the Instrument, in order to "accommodate trades of compensation securities in a wide variety of business structures."

Capital Raising Exemptions

Among the list of prospectus and registration exemptions, the following changes are worth highlighting:

  • the "Accredited Investor" exemption contains additional categories to include an investment fund managed by a registered adviser and a person acting on behalf of a fully managed account if the person is registered as an adviser in Canada or, except in Ontario, in a foreign jurisdiction.

  • a new "Private Issuer" exemption (welcome back!) will replace the closely-held issuer exemption in the existing OSC Rule 45-501 and the closed company exemption in Quebec.

  • the "Minimum Amount Investment" returns and the prescribed minimum amount for all jurisdictions is set at $150,000, payable in cash at the time of the trade.

  • the "Family, Friends and Business Associates" exemption will be available in all jurisdictions except Ontario. It applies to executive officers, directors and control persons of the issuer and certain of their close family, friends and business associates. Saskatchewan requires a signed risk acknowledgment from close friends and business associates.

  • the "Family, Founder and Control Person" is an Ontario exemption for founders, affiliates of founders, control persons and certain family members of an executive officer, director or founder of the issuer.

  • the "Affiliates" exemption, relating to trades by an issuer in a security of its own issue to an affiliate of the issuer purchasing as principal will be a new exemption for most jurisdictions, except in Ontario.

  • the "Offering Memorandum" exemption will not be adopted by Ontario. There will be two versions of this exemption, one for British Columbia, New Brunswick, Nova Scotia and Newfoundland and Labrador, and another for Alberta, Manitoba, Northwest Territories, Nunavut, Prince Edward Island, Quebec and Saskatchewan. The primary difference between the two versions is that the latter requires purchasers to either be "eligible investors" as defined in the Instrument, or to purchase securities at an aggregate acquisition cost that is less than $10,000.

Old Friends-But With New Limitations

  • the proposed return of the private issuer and $150,000 exemptions, albeit in slightly modified form, is welcome in Ontario, as these exemptions were frequently very useful and have been missed. The closely-held issuer exemption, which replaced the old private company exemption, was fraught with traps for the unwary, and the accredited investor exemption was on occasion just not broad enough.

  • a new restriction, however, is proposed on the use of each of the accredited investor and $150,000 exemptions. An accredited investor includes a person, other than an individual or certain funds, with net assets of at least $5 million according to its most recent financials. Despite this, the proposed exemption would not be available to such a person if the person is "created primarily" to purchase securities in reliance on prospectus exemptions or is "used primarily" to purchase securities under "these" (the meaning of this word is unclear) exemptions. Similar limitations apply to all entities in the case of the proposed new $150,000 exemption. The reasons for these limitations are not entirely clear, especially in the case of the accredited investor exemption, and they could pose a number of (probably unintended) difficulties for entities that would otherwise be considered sophisticated and that might wish to participate in a substantial private placement.

  • the new $150,000 exemption would also require payment in cash at the time of the purchase, creating a more restrictive situation than existed in the past, when obligations in that amount could be incurred instead.

Transaction Exemptions

Certain exemptions that are transactional in nature relate to:

  • trades made in connection with an amalgamation, merger, reorganization, arrangement, dissolution or winding-up of an issuer.

  • an asset acquisition with a fair value of not less than $150,000.

  • an acquisition of mining, petroleum or natural gas properties or any interest in them.

  • securities issued to settle bona fide debt of the reporting issuer owed to a creditor.

  • an issuer's acquisition or redemption of its own securities.

  • trades pursuant to take-over bids and issuer bids.

Investment Fund Exemptions

Additional exemptions pertaining solely to investment funds include:

  • reinvestments allowing trades of securities of the issuer to existing security holders of the issuer under a plan, if the plan permits the security holder to direct that "dividends or distributions out of earnings, surplus, capital or other sources" payable in respect of the issuer's securities be applied to the purchase of additional securities of the same class.

  • additional investments in investment funds if the purchaser has initially purchased securities at a cost of not less than $150,000, paid in cash, or if the net asset value of those securities is at least $150,000 at the time of the trade.

Employee, Executive Officer, Director and Consultant Exemptions

  • exemptions will be available for trades to employees, executive officers, directors and consultants, and are based on the current MI 45-105, with some modifications.

Miscellaneous Exemptions

Exemptions available in the miscellaneous category of the Instrument include trades relating to:

  • isolated trades.

  • trades to and among underwriters.

  • trades of "debt securities" that are rated and issued or guaranteed by governments, "Canadian financial institutions" and "Schedule III banks."

  • trades in non-convertible negotiable promissory notes or commercial paper maturing within one year of issue and with an "approved credit rating."

  • trades in non-syndicated mortgages on real property by a registered or licensed person.

  • trades in a security evidencing indebtedness "secured by or under" a security agreement for the acquisition of personal property if the security is not offered for sale to an individual.

  • trades in an evidence of deposit issued by a "Schedule III bank" or an association governed by the Cooperative Credit Associations Act (Canada).

  • conversion, exchange or exercise of securities automatically, at the option of the holder or at the option of the issuer.

  • in Ontario only, certain registration exemptions for trades in Ontario by market intermediaries are removed, preserving Ontario's current universal registration regime.

Registration Only Exemptions

An exemption from the registration requirements would be available for trades:

  • under judicial procedures such as the probate of estates, receivership, bankruptcy, liquidation or judicial sale.

  • by lawyers, accountants, engineers, teachers, notaries in Quebec and publishers and writers for newspapers, magazines or business journals under certain circumstances.

  • there is an exemption from the requirement to be registered as an adviser for registered investment dealers who manage the investment portfolios of clients through discretionary authority, but otherwise must comply with the rules and policies for portfolio managers set out by the Investment Dealers Association of Canada. In Ontario, a registered investment dealer must also provide the OSC with the names of partners, directors, officers or employees designated and approved to make investment decisions.

Control Block Distributions

"Eligible institutional investors" (as defined in NI 62-103) will continue to be exempt from the prospectus requirements in connection with "control block distributions."

TSX Venture Exchange Offerings

Except for Ontario, there would be an exemption from the prospectus requirements for TSX Venture Exchange issuers that file a TSX Venture Exchange offering document and comply with certain other requirements.

Report of Exempt Distribution

Form 45-106F1

Changes to Existing Exemptions in Ontario based on NI 45-106

As discussed above, Ontario will experience changes to its existing exemptions as a result of the Instrument, including:

  • Minimum amount exemption - the prescribed minimum amount is $150,000, payable in cash at the time of trade.

  • Private issuer exemption - will replace the closely-held issuer exemption currently set out in OSC Rule 45-501.

  • Securities for debt exemption - currently available in British Columbia, but will be available pursuant to the Instrument in all provinces, with guidance on the appropriate circumstances of usage contained in the companion policy.

  • Schedule III banks - based on the fact that Schedule III banks have been receiving relief from the registration and prospectus requirements by way of exemptive orders for several years.

Consequential Amendments and Repeals as a Result of NI 45-106

Amendments

  • consequential changes will be made to NI 33-105 Underwriting Conflicts, NI 45-101 Rights Offerings, NI 62-103 The Early Warning System and Related Take-Over Bid and Insider Reporting Issues.

  • MI 45-102 Resale of Securities has been amended to include Quebec. With Quebec's inclusion, 45-102 would become a national instrument. Other revisions include updating definitions, removing obsolete transitional provisions and revising appendices to incorporate the exemptions contained in the Instrument and transitional provisions for current exemptions.

  • in Ontario, the resale provisions currently set out in both the existing Rule 45-501 and MI 45-102 have been consolidated into the amended MI 45-102. In the Instrument and the revised 45-501, the concept of "founder" has replaced the concept of "promoter" in many cases. However, the current Ontario resale regime for securities acquired under the existing Ontario promoter exemptions before the coming into force of the Instrument and the revised 45-501 will apparently be maintained, which adds a lot of extra complexity. Going forward, if a promoter or founder acquires a security under the exemptions in the Instrument and the revised 45-501, the first trade will be subject to either a restricted period or a seasoning period.

  • in Ontario, amendments will be made to update OSC Rules 13-502 Fees, 31-503 Limited Market Dealers, 91-501 Strip Bonds and 91-502 Trades in Recognized Options according to the securities legislative references contained in the Instrument. Replacements will be made to OSC Rules 45-502 Dividend or Interest Reinvestment and Stock Dividend Plans and 81-501 Mutual Fund Reinvestment Plans by sections 2.2 and 2.18 of NI 45-106, respectively.

Misrepresentations in Ontario

  • requirements relating to the statutory right of action and right of rescission referred to in section 130.1 of the Securities Act (Ontario), for misrepresentations, would apply in the use of an offering memorandum in connection with a distribution made in reliance on the following exemptions: accredited investor, private issuer, family, founder and control person (Ontario), affiliates, additional investment in investment funds, and government incentive security.

  • however, section 130.1 would not apply in respect of an offering memorandum delivered to a Canadian financial institution, a Schedule III bank, the Business Development Bank of Canada or a subsidiary of any of the foregoing as a prospective purchaser.