Canadian Securities Law : Canadian Securities Lawyer & Attorney : Stikeman Elliott Law Firm : Montreal, Ottawa, Calgary, Vancouver, Montreal, Toronto

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.

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.

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.

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.

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.

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.

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.

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.

 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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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."

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.

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.

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.

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

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.