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Proposed National Instrument 81-102 and Companion Policy 81-102 and Rescission of National Policy Statement No. 34 and National Policy Statement No. 39
Proposed National Instrument 81-102 and Companion Policy 81-102 and Rescission of National Policy Statement No. 34 and National Policy Statement No. 39
NOTICE OF PROPOSED NATIONAL INSTRUMENT 81-102 AND
COMPANION POLICY 81-102CP AND RESCISSIONOF
NATIONAL POLICY STATEMENT NO. 34 AND
NATIONAL POLICY STATEMENT NO. 39 - MUTUAL FUNDS
Substance and Purpose of Proposed National Instrument and Companion Policy
The proposed National Instrument and Companion Policy are a reformulation of National Policy Statement No. 39 ("NP39"), which they will replace.1 Throughthese proposed instruments, the Canadian Securities Administrators (the "CSA") seek to continue the regulatory regime applicable to publicly offered mutualfunds currently embodied in NP39.
The proposed National Instrument and Companion Policy are initiatives of the CSA, and the proposed National Instrument is expected to be adopted as a rule ineach of British Columbia, Alberta, Ontario and Nova Scotia, as a Commission regulation in Saskatchewan, and as a policy in all the other jurisdictionsrepresented by the CSA. The proposed Companion Policy is expected to be implemented as a policy in all of the jurisdictions represented by the CSA.
The intent of the CSA in preparing the proposed National Instrument and Companion Policy was to ensure that these instruments remain largely consistent withthe regulatory regime provided by NP39, having regard to the on-going review of mutual fund regulation being conducted by the CSA in considering the reportof Ontario Commissioner Glorianne Stromberg2 (the "Stromberg Report").
The CSA decided to reformulate NP39 separately from consideration of the recommendations of the Stromberg Report. The consideration of that report was tobe undertaken in a parallel process that involved a significantly wider group of people, and operated within a different time frame, than the reformulation process.The CSA wanted each process to be able to proceed without the complications involved with attempting to integrate the processes.
The consideration of the Stromberg Report commenced in June 1995 when the CSA endorsed the establishment of the Investment Funds Steering Group, a jointregulatory and industry advisory committee, to consider the recommendations of the Report. The Steering Group released a report outlining its views on thoserecommendations from an industry perspective in November 1996.3
The CSA have already endorsed proposals that respond to two major recommendations made in the Stromberg Report. The CSA will shortly publish forcomment proposed National Instrument 81-105 Mutual Fund Sales Practices. That instrument is the successor to the proposed Ontario Securities Commission("OSC") Rule on mutual fund sales practices that was published for comment in August 1996 at (1996) 19 OSCB 4727. The CSA have also published forcomment a concept proposal prepared by the CSA Mutual Fund Committee regarding revisions to the disclosure system applicable to mutual funds.4 Theconcept proposal (subject to any modification made as a result of comments made on it) will likely be developed into a national instrument to replace NationalPolicy Statement No. 36 ("NP36"). The CSA may consider incorporating the disclosure requirements contained in the proposed National Instrument into thenational disclosure instrument and accordingly, the final version of the proposed National Instrument may be amended in this regard at a later date.
The CSA have identified priorities and methods for implementation of the other major recommendations made in the Stromberg Report, as commented on by theSteering Group. On May 15, 1997, the CSA released the Report of the CSA Investment Funds Implementation Group, a high-level CSA committee establishedto consider how the CSA could implement the Stromberg Report and the subsequent report of the Investment Funds Steering Group.5 Implementation ofcertain recommendations may result in amendments to the proposed National Instrument and Companion Policy at a later date.
CSA Approach to Reformulation
The CSA approached each provision of NP39 with four purposes.
First, consideration was given to whether the relevant provision should be carried forward as a rule or regulation (collectively, a "rule") of those members of theCSA that have rule-making or regulation-making authority. Provisions appropriately characterized as rules have been included in the proposed NationalInstrument; provisions of NP39 that provide useful
guidance to participants in the mutual fund industry, but that are not in the nature of mandatory requirements or prohibitions, have been included in the proposedCompanion Policy.
Second, the drafting of each provision of NP39 was reviewed in an attempt to ensure that legislative certainty and clarity is achieved in the proposed NationalInstrument and that clarity is achieved in the Companion Policy.
Third, the CSA considered whether the regulatory purpose behind each provision of NP39 was still appropriate. In most cases, no substantive changes havebeen proposed to the various provisions of NP39 pending completion of the Stromberg Report review process described above.
Fourth, the CSA considered whether NP39 contains any regulatory gaps or out-dated regulations due to changes in the industry since the 1988 compilation ofNP39 that should be filled or replaced by new rules. As a result of this consideration, the CSA are proposing a number of substantive changes to NP39,primarily to update the regulation of mutual funds to reflect current practice or changes in the industry.
This Notice summarizes in a general manner the proposed National Instrument and Companion Policy and highlights the more significant changes made in theproposed National Instrument. Appendix A to this Notice, entitled "Summary of Major Changes Made in National Instrument 81-102 From National PolicyStatement No. 39", outlines the substantive changes from NP39 proposed in the National Instrument. The Concordance Table that is being published with thisNotice outlines the treatment of each provision of NP39 in the proposed instruments. Further background and explanation of changes are contained in thefootnotes contained in each instrument.
Substance and Purpose of Proposed Instruments
The proposed National Instrument is designed to replace NP39 and will regulate all publicly offered investment funds that fall within the definition of "mutualfund" contained in Canadian securities legislation. Accordingly, all publicly offered investment funds that give investors the right to redeem securities on demandat a price based on the net asset value of those securities will be required to comply with the proposed National Instrument. Specialized mutual funds such aslabour sponsored investment funds, mortgage funds and commodity pools will generally be required to comply with the proposed National Instrument and alsowith applicable securities regulation that is in addition to, or in partial substitution for, the provisions of the proposed National Instrument.6
Regulation of mutual funds by Canadian securities regulatory authorities has resulted from the primary regulatory need to ensure that the key feature of mutualfunds is achieved; that is, the right of investors to redeem securities on demand. Other constraints have been deemed necessary due to the public distribution ofsuch investment vehicles. The authors of a commentary on a proposed federal mutual fund statute published in 1974 described the rationale (which is equallyrelevant in 1997) for mutual fund regulation of the nature provided for in NP39 and proposed by the proposed National Instrument, as follows:
"Constraints inherent in the mutual fund form of organization result largely from the availability of the right to redeem which is the key attribute of a mutual fund.This right dictates constraints to avoid investments that would result in portfolios which could not be precisely valued or would be so illiquid as to make theredemption right unrealistic. This necessity of liquidity accentuates the need which exists with any financial intermediary to prevent misuse of assets. The factthat shares of most mutual funds are in the course of continuous public distribution requires special regulation of the sales function. Constraints inherent in thenature of the market to which mutual funds have historically made their greatest appeal include the necessity of rules to prevent the investor who looks on themutual fund as a long term savings vehicle from being subject to the risks of an unusual or highly leveraged investment portfolio. However, if possible, the rulesshould be so formulated as not to prevent the organization of mutual funds with distinctive investment objectives designed to appeal to classes of investors withdistinctive wishes or requirements."7
The purpose of the proposed Companion Policy is to state the views of the CSA on various matters relating to the proposed National Instrument.
Summary of Proposed National Instrument
Part 1. Section 1.1 contains definitions of terms and phrases used in the proposed National Instrument that are not defined in National Instrument 14-101Definitions8. The National Definitions Instrument sets out definitions for commonly used terms and definitions of terms used in more than one nationalinstrument and should be read together with the proposed National Instrument.
The proposed National Instrument contains an explanatory footnote at the first place in the proposed National Instrument where a term or phrase that is definedin the National Definitions Instrument is used. The following terms and phrases defined in the National Definitions Instrument are used in the proposed NationalInstrument and Companion Policy:
"Canadian financial institution"
"Canadian securities legislation"
"Canadian securities regulatory authorities"
"person or company"
"securities regulatory authority"
For the most part, the definitions contained in section 1.1 are based on, and are very close to, the definitions contained in NP39. Certain of the definitions arenew and include definitions of terms used in NP39 but not defined in that policy.
Appendix A highlights all significant changes or clarifications made to definitions contained in NP39 and provides a cross reference to the place in the proposedNational Instrument where such definitions are used. Definitions of terms or phrases where more significant clarifications or changes to NP39 are proposedinclude:
"advertisement" and the related definitions of "sales communication" and "reports to securityholders" - used in Part 15 prescribing certain restrictions on the useof sales communications by mutual funds and other industry participants;
"asset allocation service" and the related definition of "participating fund" - used in Part 15 prescribing restrictions on the use of sales communications relating toasset allocation services and their participating funds;
"cash cover" and the related definitions of "cash equivalent", "permitted supranational agency", "approved credit rating", "approved credit rating organization"and "synthetic cash" - used in the requirements to be followed when a mutual fund uses certain permitted derivatives for non-hedging purposes;
"hedging" and the related definition of "currency cross hedging" - used in Part 2 prescribing requirements for the use of permitted derivatives;
"illiquid asset" and the related definitions of "public quotation" and "restricted security" - used in Part 2 prescribing investment restrictions on mutual funds;
"manager" - used throughout the proposed National Instrument;
"money market fund" and the related definitions of "cash equivalent", "permitted supranational agency", "approved credit rating", and "approved credit ratingorganization" - used in Part 15 prescribing restrictions on representations made in sales communications or otherwise; and
"significant change" and the related definition of "timely disclosure requirements" - used in Part 5 prescribing when certain actions must be taken by mutualfunds.
Section 1.2 sets out the application of the proposed National Instrument. It applies to all mutual funds and also regulates certain activities of industryparticipants that pertain to mutual funds. The application to mutual funds is limited to those that are reporting issuers and have issued securities under aprospectus at some time in their history. Through this section, the CSA intend to clarify that publicly offered mutual funds must continue to comply with theapplicable sections of the proposed National Instrument even if their securities are no longer being offered for sale in a jurisdiction.9
Subsection 1.2(2) provides that sections, parts, classes or series of a class of a mutual fund that are each referable to a separate and distinct investment portfolioare considered separate mutual funds for the purposes of the proposed National Instrument.
Part 2. Part 2 contains restrictions on the investments, including those in derivative instruments, that can be made by mutual funds. Sections 2.1 and 2.2 carryforward substantially the provisions concerning the investment restrictions and practices to be followed by mutual funds and their investment managers containedin sections 2.04 and 2.05 of NP39, with modifications as described in Appendix A and the footnotes to the relevant provisions.
The CSA are proposing two significant amendments to the list of investment restrictions and practices contained in NP39 relating to the ability of mutual fundsto invest in illiquid assets or restricted securities and in other mutual funds.
Paragraph 2.04(1)(f) of NP39 provides that a mutual fund may not invest in "restricted securities" (as defined) "if following such purchase more than 10% of thetotal assets of the mutual fund (taken at market value at the time of purchase) would consist of illiquid investments". Subsection 2.05(2) of NP39 prohibits amutual fund from investing more than "10% of its net assets (taken at market value at the time of investment) in illiquid investments". The proposed NationalInstrument does not carry forward paragraph 2.04(1)(f) of NP39, since substantively, this provision is covered by the restriction against investment in illiquidassets and is better dealt with by a modification to the definition of "illiquid asset". The proposed National Instrument defines "illiquid asset" in paragraph (b) ofthe definition to include those "restricted securities" that are illiquid assets, namely those securities that cannot be sold due to a representation, undertaking oragreement by the mutual fund or by the predecessor in title of the mutual fund. Not all securities that fall within the definition of "restricted securities" arenecessarily "illiquid assets"; for example, securities subject to hold periods imposed by securities legislation (being securities "the resale of which is restricted orlimited ... by law") may be sold at a market price under prospectus exemptions.
Subsection 2.05(2) of NP39 has been retained in the proposed National Instrument as a "purchase test". The test set out in paragraph 2.1(1)(f) must be compliedwith at the time of purchase of new illiquid assets by mutual funds. The proposed National Instrument imposes an additional restriction in paragraph 2.1(1)(g)that requires a mutual fund to ensure that at any time, no more than 10 percent of its net assets, taken at market value, are invested in illiquid assets for anunbroken period of 30 days or more. The CSA are proposing this amendment to the list of NP39 investment restrictions and practices to ensure that thefundamental feature of mutual funds, the ability of investors to redeem securities on demand, is achieved. The CSA recognize that a mutual fund may find itselfwith more than 10 percent of its net assets invested in illiquid assets due to market forces beyond its control. Therefore, paragraph 2.1(1)(g) has been drafted toprovide for a 30 day "cure" period during which a mutual fund could either seek an exemption (based on its circumstances) or manage its assets so as to bringitself onside with the restriction.
The CSA are proposing no major changes to the prohibition contained in NP39 against mutual funds investing in other funds (the "fund of funds" provision)pending a more thorough policy review of the fund of funds issue by the CSA that is expected to be conducted as part of the on-going consideration of theStromberg Report.10 However, paragraph 2.1(1)(m) represents the CSA's position on those investments in other mutual funds that may be made by mutualfunds, without prior regulatory approval. The major substantive change from paragraph 2.04(1)(k) of NP39 is that the proposed National Instrument limits amutual fund from investing more than 10 percent of its assets in other mutual funds. The CSA understand that some industry participants read paragraph2.04(1)(k) of NP39 as permitting a mutual fund to invest up to 10 percent of its net assets in one mutual fund, and, conceivably, to invest 100 percent of its netassets in ten different mutual funds, all without seeking regulatory approval under NP3911. The CSA are unaware that any mutual fund has so structured itsportfolio and are proposing the aggregate limit as an appropriate limit on investments in other mutual funds that may be made without regulatory approval,pending the more fundamental review of fund of funds arrangements. See also the discussion of section 13.4 of the Companion Policy, which clarifies that thisreformulation of paragraph 2.04(1)(k) of NP39 is not intended to be the new "fund of funds" regime contemplated by the CSA in granting recent waivers andorders permitting fund of funds structures.
Section 2.3 governs the use of derivative instruments by mutual funds, and corresponds to section 2.07 of NP39. Few substantive modifications to the regimeestablished by NP39 are proposed; however, the CSA have clarified which provisions of the proposed National Instrument apply to the use of permittedderivatives for hedging purposes, and which apply to their use for non-hedging purposes.
The proposed National Instrument, as does NP39, prohibits the use of derivative instruments by mutual funds, other than "permitted derivatives", as defined inthe proposed National Instrument. The definition of "permitted derivatives" includes the most frequently used types of derivatives, such as options, forwards,futures and debt-like securities. The CSA are proposing no changes to the definition of "debt-like security" or to the ability of mutual funds to invest in debt-likesecurities, pending consideration of the report of a task force formed by the OSC to review the regulation of debt-like securities.
The proposed National Instrument does not include "swaps" as permitted derivatives, an exclusion that dates from 1992, the year the current NP39 derivativessections were introduced. The exclusion results from the difficulty in defining swaps and from the CSA view that detailed rules similar to those now contained insubsections 2.3(2) through (5) for other derivatives, have not been developed to govern the use of swaps by mutual funds. The CSA have not formulated anydetailed rules through the reformulation process, but have clarified via the Companion Policy that mutual funds have the ability to achieve the economicequivalent of a swap arrangement through the use of a series of forward contracts.
The proposed National Instrument continues the NP39 regime for derivative use that ensures that permitted derivatives cannot be used without the safeguardsprovided for in the instrument. There are two regimes - one for derivatives used for hedging purposes, and one for derivatives used for non-hedging purposes.The nature of these two uses is fundamentally different, so that different sets of rules providing safeguards to a mutual fund are provided in the proposedNational Instrument, consistent with NP39.
One fundamental regulatory safeguard in respect of the use of derivatives for non-hedging purposes is the requirement that non- hedging derivatives positions notexceed a certain percentage of a mutual fund's net assets. This safeguard is designed primarily to protect a mutual fund against the volatility associated with asubstantial derivatives position. This concern is not relevant for hedging uses of derivatives, since derivatives used for hedging purposes reduce volatility and therisks associated with the positions being hedged. However the proposed National Instrument clarifies that certain other safeguards, such as those relating toterm and counterparty credit requirements are as applicable to derivatives used for hedging purposes to those used as for non-hedging purposes; the requirementto maintain cash cover is not relevant to hedging derivatives and is not required.
The proposed National Instrument continues to provide, as does NP39, that the underlying interests represented by derivative positions held for non-hedgingpurposes should be aggregated with the direct holdings of a mutual fund of those underlying interests to determine the compliance of the mutual fund with theinvestment restrictions set out in subsection 2.1(1). Derivatives held for hedging purposes are not subject to this requirement to aggregate. A derivative used forhedging purposes is designed to reduce a mutual fund's exposure to risks associated with part of its portfolio, rather than increase exposure.
Subsection 2.3(2) requires mutual funds to hold cash cover in respect of their derivatives positions held for non-hedging purposes. The CSA are proposing toexpand the definition of cash cover provided for in NP39 to permit mutual funds to use "synthetic cash" in addition to "cash equivalents" to meet this obligation.The definition of "synthetic cash" included in the proposed National Instrument articulates permissable arrangements that would result in the mutual fund holdingthe economic equivalent of cash. Subsection 2.3(6) details how a synthetic cash position is quantified for purposes of satisfying cash cover requirements.
Subsection 2.3(7) imposes a new restriction limiting the aggregate exposure of a mutual fund in permitted derivatives positions to any one counterparty otherthan a clearing corporation listed in Appendix A to the proposed National Instrument. The restriction provides that the aggregate marked-to-market value ofpermitted derivatives positions held by a mutual fund with any one such counterparty cannot exceed, for an unbroken period of 30 days or more, more than 10percent of the net assets of the mutual fund. This provision is designed to be analogous to paragraph 2.1(1)(a) of the proposed National Instrument with respectto direct holdings of securities, and to protect mutual funds from excessive concentration risk.
Part 3. Part 3 sets out the initial capitalization requirements applicable to new mutual funds, as well as a prohibition on a mutual fund or its securityholders frombearing any of the costs of its organization. Part 3 is consistent with Section 3 of NP39.
Part 4. Part 4 contains the proposed National Instrument's conflict of interest provisions. Section 4.1 sets out certain investments that are prohibited for "dealermanaged mutual funds" that are unchanged from those prohibited by section 4.02 of NP39. Section 4.1 (as is section 4.02 of NP39) is a recognition of theconflicts of interest that might arise if a dealer managed mutual fund were permitted to invest in securities that are in primary distribution and are underwritten bythe dealer manager or its associate or affiliate.
Section 4.2 contains "self-dealing" provisions applicable to all mutual funds that are derived from subsection 2.05(11) of NP39. Section 4.2 includes restrictionson the purchasing and selling of securities on a principal basis between a mutual fund and the related parties noted in the section. The list of related partiesincluded in the proposed National Instrument has been expanded slightly from subsection 2.05(11) of NP39, and the additional related parties are consistent withthe types of related parties referred to in subsection 2.05(11).
As noted in Appendix A, the CSA are proposing no amendments to either subsection 2.05(11) or section 4.02 of NP39 at this time through the proposedNational Instrument. In addition, the CSA have not carried forward into the proposed National Instrument section 4.03 of NP39, which purported to give"dealer managed mutual funds" certain relief from subsection 2.05(11) of NP39 to permit principal trading in portfolio securities between those mutual funds andtheir related parties. As noted previously by the CSA, the CSA recognize that section 4.03 of NP39 may not impose appropriate terms and conditions forprincipal trading in portfolio assets between mutual funds and their related parties.12
Central to the CSA's consideration of the Stromberg Report recommendations, as commented on by the Steering Group, is a continued review of the conflict ofinterest regime applicable generally to mutual funds. The CSA do not wish to pre-empt the results of this review by proposing changes at this time to the NP39conflicts of interest regime.
The proposed National Instrument adds section 4.3 as a new section, entitled "Liability and Indemnification", which subjects mutual funds to certain provisionsthat are now formally applicable only to commodity pools in Ontario under OSC Policy Statement No. 11.4. However, CSA staff have for some years applied asimilar requirement to all new mutual funds, and section 4.3 represents a codification of that position. Section 4.3 is designed to ensure that a person orcompany providing services to a mutual fund assumes the entire responsibility for loss occasioned by the negligence or wilful misconduct of its employees,directors or officers; the section prohibits a mutual fund from relieving such a person or company from, or indemnifying it for, losses suffered by it as a result ofits negligence or wilful misconduct or actions not in the best interests of the mutual fund.
Part 5. Part 5 sets out a list of fundamental changes to a mutual fund that cannot be implemented without securityholder approval and a list of certain changesthat require the prior approval of the Canadian securities regulatory authorities. It groups the list of fundamental changes requiring securityholder approvalcontained in Section 6 of NP39 with the list of changes that require regulatory approval contained in Section 9 of NP39. The CSA propose no changes to eitherlist, except to recognize the proposed regulatory response to mergers of mutual funds and in connection with changes in control of managers of mutual funds.
The proposed National Instrument does not change the regime established by NP39 in respect of increases in fees and expenses charged to a mutual fund. TheCSA note the combination of paragraph 5.1(1)(a) and section 5.3 is such that, although increases of fees and expenses charged to a mutual fund by an unrelatedarm's length third party may be made without securityholder approval, securityholders must receive 60 days' prior notice of the increase.
The CSA are recommending that the securityholder approvals list contained in section 5.1 include a provision relating to mergers or conversions of mutual funds.Under paragraph 5.1(1)(f), mutual funds would not be permitted to merge or amalgamate with another mutual fund or to be "converted" from a mutual fundcorporation to a mutual fund trust without a securityholder vote of the fund to be terminated. Transactions of this nature have been carried out since the early1990s, with the numbers increasing significantly as a result of the amendments to the Income Tax Act (Canada) ("ITA") that provide for tax-free "roll-overs" formergers of mutual fund trusts and corporations and conversions of mutual fund corporations to mutual fund trusts.
To date, most mutual fund mergers and conversions have involved a meeting of the terminating fund. The CSA wish to ensure that securityholders of theterminating fund (or converting fund) continue to receive proxy level information concerning the transaction and have a right to vote on whether they agree to bemoved, en masse, to the continuing fund. The CSA believe that this right to vote is fundamental and should be applicable in all circumstances even if theinvestment objectives of the two funds are substantially similar.
Subsection 5.1(2) is a new provision that provides that no person or company that is a manager of a mutual fund may continue to act as the manager following adirect or indirect change of control of the person or company unless the approval of securityholders of the mutual fund has been obtained to the change ofcontrol. This provision parallels subsection 5.5(4) and existing paragraph 9.01(2) of NP39, each of which requires securities regulatory authority approval to achange in control of a manager. The CSA are proposing subsection 5.1(2) as a complement to paragraph 5.1(1)(b), which requires securityholder approval to achange of manager. The CSA have encountered a number of transactions in recent years in which control of a manager, and the senior personnel employed bythe manager, changed although the same corporate entity remained manager. The CSA believe that a change in control of a manager of a mutual fund can resultin as profound a change to the securityholders of the mutual fund as a change in manager. The CSA are of the view that the spirit, although perhaps not thewords of NP39, suggest this proposed change. Subsection 5.1(2) is designed to ensure that securityholder approval is required to be obtained for all transactionsinvolving fundamental changes to the manager of a mutual fund, whether the transaction is structured as a change of manager or as a change of control ofmanager.
Subsections 5.5(1) and (4) describe the changes that will require the prior approval of a securities regulatory authority. These changes are the same as thoseprovided in section 9.01 of NP39, being change of manager, change in control of manager and change of custodian, with mutual fund mergers, conversions andother similar reorganizations being a new addition in paragraph 5.5(1)(b).
Paragraph 5.5(1)(b) is designed to ensure that the Canadian securities regulatory authorities consider transactions in which the securityholders of a mutual fundbecome securityholders of another mutual fund as a result of the transaction. This paragraph will require direct regulatory consideration of those transactionsand will replace the highly technical applications for relief from certain provisions of NP39 and securities legislation that currently sometimes apply to thesetransactions. Section 5.7 grants relief from those provisions of securities legislation if approvals are granted under the proposed National Instrument to permitthese transactions, making separate applications for exemptions from the applicable provisions of securities legislation unnecessary. Applications for regulatoryapproval under the proposed National Instrument will not be required to reference any other section of the proposed National Instrument.
The CSA consider that certain of the transactions referred to in paragraph 5.5(1)(b) give rise to no regulatory issues that need to be considered and addressed byCSA staff through applications for regulatory approval. Subsection 5.5(2) outlines the types of transactions that, when carried out in accordance with theconditions of that subsection, address the fundamental regulatory concerns raised by these transactions and may be carried out without any application forregulatory relief. The proposed National Instrument, in effect, pre-approves those merger and conversion transactions that are carried out in accordance with theprovisions of subsection 5.5(2). The conditions to such pre-approved transactions are based on the conditions to the usual regulatory relief developed by CSAstaff over the recent past for typical mergers and conversions involving substantially similar mutual funds.13 Reference is also made to section 6.2 of theCompanion Policy that describes the CSA position regarding certain of the conditions provided for in subsection 5.5(2).
A merger, amalgamation, conversion or other similar reorganization transaction that does not fall within subsection 5.5(2) may not be carried out without theprior approval of the Canadian securities regulatory authorities. Paragraph 5.6(b) of the proposed National Instrument describes the information that must beprovided to Canadian securities regulatory authorities in connection with an application made under paragraph 5.5(1)(b) for prior approval. Section 6.3 of theCompanion Policy outlines certain of the matters that CSA staff will consider in their review of such applications.
Subsection 5.5(4) continues the NP39 requirement that regulatory approval be obtained before completion of a transaction that results in a change in control of amanager of a mutual fund. See the discussion above regarding subsection 5.1(2).
The CSA are proposing the addition of section 5.8 to the proposed National Instrument. Section 5.8 would require the mutual fund to issue a press release, file amaterial change report and file an amendment to its prospectus whenever the mutual fund experiences a change that an investor would reasonably consider to bematerial. The events that give rise to these requirements are defined as "significant changes" in the proposed National Instrument. Paragraph (a) of the definitionof "significant change" has been adapted from Rule 405 of the United States Securities Act of 1933, which is intended to define "materiality" for that statute'spurposes. Paragraph (b) of the definition of "significant change" has been derived from the definition of "material change" contained in securities legislation ofseveral jurisdictions.14 The CSA believe that changes of this nature should be publicly disclosed to investors.
Part 6. Part 6 contains the requirements for custodianship of the portfolio assets of a mutual fund and is largely consistent with Section 7 of NP39. The changesthat have been made to the custodial requirements are noted in Appendix A.
Section 6.1 of the proposed National Instrument, when combined with the definition of "custodian", gives effect to the CSA view that a mutual fund must haveone Canadian custodian and may not have more than one custodian. However, the proposed National Instrument now gives a mutual fund and its custodian theflexibility to engage Canadian sub-custodians to hold assets within Canada. Mutual funds continue to have the ability provided for in NP39 to utilizesub-custodians to hold assets outside of Canada. Subsection 6.1(3) sets out the requirements that must be complied with before a fund custodian orsub-custodian can sub-delegate custodial authority. These requirements include the obtaining of the written consent of the mutual fund if a custodian delegatescustodial authority to a sub-custodian.
Although much of Part 6 of the proposed National Instrument imposes direct obligations on custodians and sub-custodians, section 6.4 of the proposed NationalInstrument continues to prescribe the contents of custodian and sub-custodian agreements to ensure that, in particular, non-Canadian sub-custodians are requiredto comply with the applicable provisions.
Part 7. Part 7 permits certain incentive fees to be charged to mutual funds. Consistent with section 8.02 of NP39, the proposed National Instrument permits onlythose incentive fees that are based on a comparison of a mutual fund's performance to the changes in a relevant benchmark or index and that take into accountperiods in which the fund's performance does not meet or exceed the changes in the benchmark or index over the same period. NP39 requires prior approval ofthe securities regulatory authorities before an incentive fee can be charged. Section 7.1 of the proposed National Instrument replaces that requirement with adescription of acceptable incentive fees. No regulatory approval will be required under the proposed National Instrument before mutual funds can be charged anincentive fee that complies with section 7.1.
Part 8. Part 8 does not carry forward the detailed provisions of Section 10 of NP39 relating to contractual plans15. The CSA propose that no new contractualplans be permitted to be established. Any existing contractual plans will be permitted to continue if they comply with the same regulatory requirements nowcontained in NP39. The CSA understand that only a few mutual fund organizations still operate contractual plans, and that there are a wide variety of otherperiodic purchase plans available to investors in mutual funds that are less restrictive than contractual plans. Accordingly, the decision to no longer permit thesale of mutual fund securities by way of contractual plan should not impose any significant burdens on either industry participants or investors.
Part 9 and Part 10. Parts 9 and 10 contain proposed rules regarding the transmission and receipt of purchase and redemption orders, the establishment of issueand redemption prices and currency of payment, and the delivery of monies (or in specie payments) among the investor, the principal distributor and/or theparticipating dealer and the mutual fund. Part 9 combines all NP39 provisions dealing with sales of mutual fund securities and Part 10 groups together all NP39provisions dealing with redemptions of mutual fund securities. The proposed National Instrument is largely consistent with the regime established by NP39except that it provides for "T plus 3" settlement for both sales and redemptions, rather than the "T plus 5" settlement permitted by NP3916.
Section 9.1 and section 10.2 continue the regime established by NP39 that requires purchase or redemption orders to be transmitted by dealers (other thanparticipating dealers receiving such orders at an office that is not the principal office of that participating dealer) to an "order receipt office", as defined in theproposed National Instrument, on the date the order is received via courier, priority post, telephone or other electronic communication. The proposed NationalInstrument modifies NP39 to require that purchase or redemption orders received by participating dealers at offices that are not the principal office of thatparticipating dealer must be sent to the principal office of the participating dealer on the same date they are received. This modification is designed to enableparticipating dealers to maintain records of all orders placed through their salespersons.
Subsection 9.4(1) replaces subsection 12.03(5) of NP39 and sets out specific timing requirements for delivery to mutual funds of monies received byparticipating dealers in respect of purchase orders. Section 9.4 also contains other requirements relating to the delivery of monies for the purchase of securitiesand the settlement of purchases. Section 9.4 permits in specie payments for mutual fund securities, on prescribed conditions, without the need to seek the priorapproval of the Canadian securities regulatory authorities as required by NP39.
Generally speaking, section 9.4 requires payment of the issue price of the securities of a mutual fund to be made on or before the third business day after thepricing date. If payment is not made by this time, the mutual fund is required to redeem the securities that had been issued on the failed sale as if the mutual fundhad received a redemption order immediately before the close of business on the third business day after the pricing date. Analogous provisions relating to failedredemptions are contained in section 10.5. Under those provisions, dealers or managers of the mutual fund may be required to compensate the fund for lossessuffered as a result of the failed transactions. As noted in Appendix A, the rule-making authority granted to certain of those jurisdictions that have powers tomake rules does not permit the proposed National Instrument to provide those persons with the right to make claims for reimbursement to other dealers or theirclients, as is provided for in NP39. A discussion of this issue is contained in section 9.3 of the Companion Policy.
Section 10.1 clarifies what requirements are applicable to mutual funds before they may pay redemption proceeds and establishes that funds can establish theirown additional reasonable requirements as to what they must receive before they will either pay redemption proceeds or consider that a redemption order hasbeen received.
Section 10.4 imposes requirements concerning payments of redemption proceeds by a mutual fund. The section clarifies timing requirements of payments ofredemption proceeds, specifies the currency in which payment is to be made and permits in specie payments under certain conditions. The section also clarifieswhen a mutual fund's obligation to make payment of redemption proceeds is considered to have been satisfied.
As mentioned above, proposed rules regarding incomplete or failed redemption orders are contained in section 10.5. Generally speaking, if ten business dayspass after the redemption of the relevant securities and the investor has failed to satisfy the mutual fund's requirements for a completed redemption order orpayment of redemption proceeds, the fund shall issue to the investor a number of securities equal to the number of securities redeemed as if it had received anorder for the purchase of that number of securities.
Section 10.6 contains proposed rules allowing the suspension of redemptions by a mutual fund if normal trading is suspended on a securities exchange in amanner that affects the mutual fund's ability to trade more than 50 percent of its net assets, taking into account those securities that are inter-listed on variousstock exchanges. If securities of a mutual fund have already been redeemed before a suspension of trading, a mutual fund may postpone payment of any unpaidredemption proceeds during any period of suspension but its obligation to pay is not otherwise affected. Section 10.6 also provides for a system of expeditedapplications for permission to suspend redemptions.
Part 11. Part 11 regulates how monies are to be held by dealers, pending delivery to a mutual fund in respect of purchases and pending delivery to investors inthe case of redemptions. It requires principal distributors and participating dealers to account separately for all monies received for investments in, or upon theredemptions of, the securities of a mutual fund, to deposit the monies in interest bearing trust accounts, and to refrain from commingling these monies with anyother monies except for those received from the sale of, or upon the redemption of, other mutual fund securities. Part 11 also forbids the use of trust monies forthe general financing of the operations of a principal distributor or participating dealer and describes what payments may be made out of the trust accounts.
Most of Part 11 does not apply to members of the Investment Dealers Association of Canada, or of the Alberta, Montreal, Toronto, and Vancouver stockexchanges who, as members of those organizations, are subject to requirements that address the same regulatory issues.
The provisions of Part 11 are largely consistent with Section 12 of NP39.
As indicated in Appendix A, subsection 11.1(4) and subsection 11.2(4) require all interest earned on the trust accounts operated by principal distributors andparticipating dealers in accordance with Part 11, to be paid at least monthly to the relevant mutual funds. The corresponding sections in NP39 give dealers theoption of paying over interest to applicable investors. The CSA have been advised that most dealers pay over the interest to the relevant mutual funds, it beingadministratively difficult to determine which investors are entitled to the interest earned in trust accounts and having regard to the dollar amounts of suchinterest. Accordingly, the CSA have not retained the option of paying interest to applicable investors as provided for in NP39.
Section 11.2 sets out the requirements applicable to participating dealers. The corresponding section in NP39 (subsection 12.03(1) of NP39) does not recognizethat participating dealers may, from time to time, receive redemption proceeds from fund companies for distribution to the participating dealers' clients.Accordingly, section 11.2 has been drafted to contemplate that this money may be received and imposes similar requirements for participating dealers concerningthe holding of this money as for principal distributors.
Section 11.4 includes proposed provisions that are aimed at service providers providing back office administration to funds. It requires that funds, and thoseacting on behalf of funds, ensure that their contractual arrangements with service providers are such that the service providers hold monies referred to in Part 11in the same manner as Part 11 requires the monies to be held by principal distributors. Section 11.5 requires a mutual fund to ensure that all contractualarrangements made between it and service providers provide for a right of inspection in favour of representatives of the fund, its manager, trustee and principaldistributor.
Part 12. Part 12 sets out the compliance report requirements of the proposed National Instrument. The matters upon which the relevant entities must reportcompliance are unchanged from NP39. Mutual funds, principal distributors and participating dealers must report on their compliance with applicable sectionsrelating to sales and redemption procedures and commingling of money requirements. Part 12 states who is to report and the form of the report for each entityso required to report. The compliance of each relevant reporting entity with the applicable requirements must be reported on by the reporting entity's auditors inthe form required by section 5815 of the Handbook of the Canadian Institute of Chartered Accountants17.
Section 12.1(3) requires participating dealers to report on their compliance with the relevant sections in respect of their activities in distributing securities ofmutual funds to which the proposed National Instrument applies. All participating dealers are obliged to file such a report, as they are under NP39. As noted inthe form of the report attached to the proposed National Instrument as Appendix B-3, participating dealers that are members of the Investment DealersAssociation of Canada or the Alberta, Montreal, Toronto or Vancouver stock exchanges must report on their compliance with subsection 9.4(1) and subsection11.3(2) of the proposed National Instrument and all other participating dealers must report on their compliance with subsection 9.4(1) and section 11.2 of theproposed National Instrument. Participating dealers must file one report in the form attached to the proposed National Instrument in respect of all mutual fundsdistributed during the applicable financial year. The timing mandated for the preparation and filing of those reports has been changed from NP39 in order thatthe timing coincide with the time of filing of dealers' annual financial statements.
Part 13. The requirements for the calculation of the net asset value of a mutual fund are contained in Part 13 of the proposed National Instrument. Section 13.1prohibits the establishment of mutual funds that calculate net asset value only once per month, although mutual funds that calculate net asset value on this basison the date the proposed National Instrument comes into effect may continue that timing. If a mutual fund uses derivatives, it must calculate its net asset valueonce a day; otherwise mutual funds must calculate net asset value at least once per week.
Sections 13.2 and 13.3 of the proposed National Instrument are not intended to alter the requirements established by sections 14.01 and 14.02 of NP39.However, section 13.3 has been redrafted to achieve legislative certainty in the requirements imposed by section 14.02 of NP39.
The CSA have not altered the requirements for valuing derivatives set out in NP39 and section 13.5 of the proposed National Instrument essentially repeats thoserequirements. The CSA note that consideration was given to whether the proposed National Instrument could simply state that derivatives must be valued inaccordance with Canadian generally accepted accounting principles, having regard to, in particular, section 3860 of the Handbook of the Canadian Institute ofChartered Accountants. The CSA understand that the study group established by the Canadian Institute of Chartered Accountants is considering this issue andwhat further guidance should be given by the CICA to industry participants in the application of section 3860 of the Handbook in the valuation of derivatives.The CSA intend to review the final recommendations of this study group and may amend the proposed National Instrument to refer to Canadian GAAP if theCSA are satisfied that Canadian GAAP provides sufficient guidance.
Part 14. Part 14 contains the proposed requirements for establishing record dates for the making of distributions and payment of dividends by mutual funds and isessentially unchanged from section 15.01 of NP39.
Part 15. Part 15 deals with advertising and sales communications concerning mutual funds to which the proposed National Instrument is applicable and is largelyfaithful to the regime established by NP39. Part 15 continues to constitute an "all-inclusive" code for mutual fund sales communications as did Section 16 ofNP39. As such, mutual funds and parties on behalf of mutual funds are permitted to disseminate only those sales communications for mutual funds that complywith the rules set forth in the proposed National Instrument.
The definition of "sales communication" has been expanded to include all oral and written communications made to existing securityholders, and includes oralcommunications made at investor conferences or seminars.
The proposed National Instrument, as does NP39, regulates what type of mutual fund may describe itself as a "money market fund". However, the definition of"money market fund" contained in the proposed National Instrument differs from the definition contained in NP39. Three main changes are proposed; theportfolio of money market funds must consist of "cash equivalents", as defined in the proposed National Instrument; through the definition of "cash equivalents",money market funds must hold instruments with a remaining term to maturity of 365 days or less; and the portfolio of money market funds must have a dollarweighted term to maturity not exceeding 90 days.18
Section 15.4 of the proposed National Instrument provides that mutual funds that have not been publicly offered for more than one year (so-called "youngfunds") cannot use performance data in their sales communications, except where such communications are being delivered to existing investors only. Thisrequirement replaces the comparable, although indirect, prohibition on this practice contained in NP39.19
Part 16. Part 16 combines in one section the disclosure and filing requirements contained in NP39 that are in addition to those contained in NP36. Section 16.9imposes on mutual funds that do not use NP36 an obligation to comply with certain provisions of NP36 in the preparation of their prospectuses. This is not asubstantive change from NP39, but is a necessary provision because disclosure requirements contained in NP39 that substantially duplicate those contained inNP36 have not been repeated in the proposed National Instrument. The CSA note that Part 16 may be deleted from the final version of the proposed NationalInstrument and included in the proposed national instrument to replace NP36 once the proposed national disclosure instrument is finalized.
Part 17. Part 17 contains new provisions that have been developed by CSA staff over the recent past in order to deal with management fees being paid directly bysecurityholders (and not indirectly by the mutual fund) and management fee rebate or distribution programs. Section 17.1 imposes disclosure obligations ifmanagement fees are payable directly by securityholders. Section 17.2 imposes obligations to ensure that management fee rebate or distribution programs do notresult in adverse tax consequences to the mutual fund or to its securityholders and that disclosure of this is made in the fund's prospectus or simplifiedprospectus. The CSA note that the disclosure requirements of Part 17 may also be deleted from the final version of the proposed National Instrument andincluded in the proposed national instrument to replace NP36 once that instrument is finalized.
Part 18. Part 18 contains the requirements relating to the disclosure of derivatives positions of mutual funds in their financial statements, and certain othermiscellaneous requirements concerning financial statement disclosure. The CSA considered replacing the detailed rules concerning derivatives financialdisclosure with a general requirement that this financial disclosure be made in accordance with Canadian GAAP. However, consistent with the CSA approach toderivatives valuation, the CSA decided to await the final results of the study group of the Canadian Institute of Chartered Accountants before making thisdetermination.
Part 19. Part 19 is a reformulation of National Policy Statement No. 34 entitled "Unincorporated Issuers: Requirement to Maintain a Register of SecurityHolders". This National Policy Statement is proposed to be rescinded. Part 19 requires mutual funds that are unincorporated to maintain securityholderregisters, and make them available to securityholders on the terms provided for in the proposed National Instrument. This Part does not apply to mutual fundsstructured as corporations, as those entities are governed by the applicable provisions of their corporate statutes.
Part 20. Section 20.1 permits the regulator or, except in the case of Ontario, the securities regulatory authority to provide exemptions from the proposedNational Instrument. Section 20.2 provides that, in certain circumstances, the granting of such an exemption is evidenced by the issuance of a receipt for theprospectus or simplified prospectus of a mutual fund.
Subsection 20.3(1) provides that mutual funds that have obtained exemptions from, or approvals under provisions of NP39 that are being carried forwardsubstantively unchanged to the proposed National Instrument, are exempt from the equivalent provision of the proposed National Instrument on the same termsand conditions, if any, as the exemption from NP39 provisions, except to the extent that the regulator or securities regulatory authority has, under subsection20.3(4), limited the ability of a mutual fund to rely on subsection 20.3(1) in connection with a particular matter. Section 16.8 of the proposed NationalInstrument is related to subsection 20.3(1). Section 16.8 mandates disclosure of any exemptions or approvals granted to permit a mutual fund's particularoperations; this requirement would include exemptions granted under NP39, as well as exemptions granted under the proposed National Instrument after itcomes into force. Subsection 20.3(2) provides that all approvals of incentive fee arrangements granted under section 8.01 of NP39 will continue to be effectiveon the same terms and conditions after the effective date of the proposed National Instrument so long as disclosure of the incentive fee arrangements is made inthe prospectus or simplified prospectus of the relevant mutual funds.
Subsection 20.3(3) requires that a mutual fund relying on a previously granted exemption or waiver from NP39 to carry on its operations that is "grandfathered"by subsection 20.3(1) must notify the regulator of the applicable jurisdictions as to the existence of the exemption or approval being relied on and point outwhere this exemption or approval is disclosed in the prospectus or simplified prospectus of the mutual fund. The proposed National Instrument requires that thisnotice be given to each applicable CSA jurisdiction at the time the first pro forma prospectus or pro forma simplified prospectus of the mutual fund is filedfollowing the coming into force of the National Instrument. The notice must also identify the provision in the proposed National Instrument that is substantiallysimilar to the applicable provision of NP39 from which the CSA granted the approval exemption or waiver.
Through this notice mechanism, staff of the CSA will be able to ensure that their records of previously granted exemptions or approvals are maintainedup-to-date. The CSA also wish to ensure that mutual funds that deviate from the provisions of the proposed National Instrument do so only in reliance uponproperly applied for, and granted, exemptions or approvals from the predecessor policy statements to the proposed National Instrument. The CSA will be in aposition to better ensure consistency in considering future exemptions from the proposed National Instrument.
Subsection 20.3(4) gives the regulator or securities regulatory authority in a jurisdiction the ability to limit or remove the ability of a mutual fund to rely uponsubsection 20.3(1) in connection with a particular matter, subject to such conditions or restrictions as the may be imposed by the regulator or securitiesregulatory authority, if he, she or it considers it in the public interest and after giving the mutual fund the opportunity to be heard. This subsection is designed toparallel provisions in certain provincial securities legislation that gives the staff (for example, in Ontario, the Executive Director) the ability to apply to theapplicable securities regulatory authority (for example, in Ontario, the OSC) to vary or revoke a previously made decision of the securities regulatory authority.
Part 21. Section 21.1 provides for the inclusion of an effective date of the proposed National Instrument. No effective date is included in the proposed NationalInstrument at this time; the CSA anticipate that the proposed National Instrument will come into force on a date that is approximately six months after it hasbeen adopted by the CSA jurisdictions, in order to provide a transitional period for market participants.
Section 21.2 provides that the prospectus of a mutual fund for which a receipt has been obtained before the proposed National Instrument has come into force isnot required to comply with the specific disclosure requirements of the proposed National Instrument, which are primarily contained in Parts 16 and 17 of theproposed National Instrument. This provision permits a mutual fund to continue to use a prospectus that is receipted before the proposed National Instrumentcomes into force, and is designed to ease the transition required to be made by mutual funds in complying with the proposed National Instrument. The provisiondoes not require an amendment of a prospectus of a mutual fund to be prepared and filed after the proposed National Instrument comes into force; howevermutual funds may amend their prospectus to ensure that the prospectus continues to contain full, true and plain disclosure.
Summary of Proposed Companion Policy
Part 1. Part 1 of the proposed Companion Policy indicates that the purpose of the Policy is to state the views of the CSA on matters involving the proposedNational Instrument, including the interpretation of terms used in the Instrument, recommendations on ensuring compliance with the Instrument, circumstances inwhich relief has been granted from the requirements of NP39, and recommendations concerning applications for relief from, or approval under, the provisions ofthe proposed National Instrument.
Part 2. Part 2 contains comments on terms defined in the proposed National Instrument.
Part 3. Part 3 elaborates upon the proposed National Instrument's rules regarding certain types of investments.
In particular, section 3.1 describes the relief given by the CSA from the rule now proposed to be contained in paragraph 2.1(1)(a) of the proposed NationalInstrument, which prevents a mutual fund from investing more than 10 percent of its net assets in the securities of any one issuer. Relief from this requirementhas been granted under NP39 to permit international bond funds to pursue their investment objectives on the terms and conditions set out in section 3.1 of theCompanion Policy.
Part 3 also provides the views of the CSA on investment restrictions that involve the payment of instalments of purchase price, evidences of indebtedness, andsecurities repurchase and reverse repurchase agreements. The CSA Mutual Fund Committee is working with The Investment Funds Institute of Canada indetermining whether mutual funds should be permitted to use securities repurchase agreements, and, if so, what conditions should be applicable in respect ofsuch use. Once this CSA Committee has completed its review of this issue, the CSA will consider proposals to amend the proposed National Instrument in thisregard presented by the Committee.
Part 4. Part 4 clarifies certain matters concerning the use of permitted derivatives.
Part 5. Section 5.1 contains a reminder that meetings of securityholders of a mutual fund must comply with the requirements of National Policy Statement No.41, or any instrument replacing it, regarding length of the notice period.
Section 5.2 contains a discussion concerning the possible liability of securityholders of a mutual fund beyond the amount of their original investment.
Part 6. Section 6.1 provides guidance to applicants seeking approvals of the Canadian securities regulatory authorities relating to proposed changes in a managerof a mutual fund, proposed changes in the control of a manager of a mutual fund, and proposed mergers or conversions of mutual funds.
Section 6.1 sets out the information that the Canadian securities regulatory authorities would find helpful in connection with their assessment of the integrity andcompetence of a proposed management group of a mutual fund.
Sections 6.2 and 6.3 describe matters that should be taken into account by industry participants proposing to consolidate mutual funds within a fund family andthat the CSA recommend be addressed in any application for regulatory approval that may be required.
Section 6.5 describes a number of issues relating to sales communications and performance data of mutual funds that have completed merger or relatedtransactions.
Part 7. Part 7 clarifies some of the requirements of the proposed National Instrument regarding the custodianship of portfolio assets. It comments upon thestandard of care required of custodians and sub-custodians, and upon the identity of those depositories and clearing houses that are authorized to operatebook-based systems.
Part 8. Part 8 contains a reminder of the nature of contractual plans.
Part 9. Part 9 pertains to the sale and redemption provisions of the proposed National Instrument. Section 9.1 describes the regulatory goals behind thoseprovisions. Section 9.2 recommends procedures to mutual funds relating to the receipt of orders. Section 9.3 reminds dealers that the proposed NationalInstrument does not carry forward the provisions from NP39 that deal with dealers' ability to make certain claims against other dealers or clients in the context offailed sales or redemptions.
Part 10. Part 10 contains various comments concerning the rules regulating sales communications contained in the proposed National Instrument and inparticular sets out specific examples of misleading sales communications that would be contrary to section 15.2 of the proposed National Instrument.
Part 11. Part 11 contains discussion on a number of prospectus disclosure requirements of the proposed National Instrument.
Section 11.1 provides additional detail as to the disclosure required by paragraph 16.1(c) of the proposed National Instrument of the policies and practices of themutual fund in managing risks associated with derivatives use. Section 11.2 provides examples of details that could be contained in disclosure required by theproposed National Instrument on management fee rebate or distribution programs. Section 11.3 contains a reminder that disclosure that a mutual fund'ssecurities are eligible investments for certain entities may be misleading if the disclosure does not reflect the continuous nature of the offering of mutual fundsecurities.
Part 12. Part 12 contains a suggestion that blacklined copies of prospectuses and annual information forms of mutual funds be submitted along with the otherapplicable documents in pro forma prospectus renewal filings.
Part 13. Part 13 sets out the procedure to obtain, in more than one jurisdiction, an approval under, or an exemption from, the proposed National Instrument.
Section 13.2 confirms that there is generally no need to apply again for an exemption previously granted, unless there has been some change in an important factrelating to the granting of the exemption. This section also reminds industry participants of the requirements that may be applicable in Quebec with respect toapplications that must be made for relief under the Securities Act (Quebec).
Section 13.3 provides further explanation in respect of the extent of section 20.3 of the proposed National Instrument.
Section 13.4 refers to waivers and orders given by the CSA in recent years concerning "fund of funds" that expire when legislation or a CSA policy or rule comesinto force that effectively provided for a new "fund of funds" regime. Section 13.4 notes that the coming into force of the proposed National Instrument will nottrigger the expiration of those waivers and orders. The amendments made to paragraph 2.01(1)(k) of NP39 in paragraph 2.1(1)(m) of the proposed NationalInstrument do not constitute a new "fund of funds" regime.
Terms used in the proposed Companion Policy that are defined or interpreted in the proposed National Instrument or a definition instrument in force in thejurisdiction should be defined or interpreted in accordance with the proposed National Instrument or definition instrument, unless the context otherwise requires.
Authority for Proposed National Instrument (Ontario)
In those jurisdictions in which the National Instrument is to be adopted or made as a rule or regulation, the securities legislation in each of those jurisdictionsprovides the securities regulatory authority with rule-making or regulation-making authority in respect of the subject matter of the proposed National Instrument.
In Ontario, the following provisions of the Securities Act (Ontario) (the "Act") provide the OSC with authority to make the proposed National Instrument.Paragraph 143(1)13 of the Act authorizes the OSC to make rules regulating trading or advising in securities to prevent trading or advising that is fraudulent,manipulative, deceptive or unfairly detrimental to investors. Paragraph 143(1)31 of the Act authorizes the OSC to make rules regulating mutual funds ornon-redeemable investment funds and the distribution and trading of the securities of the funds, including in connection with certain enumerated matters.Paragraph 143(1)35 authorizes the OSC to make rules regulating or varying the Act in respect of derivatives, including prescribing requirements that apply tomutual funds. Paragraph 143(1)39 of the Act authorizes the OSC to make rules requiring or respecting the media, format, preparation, form, content, execution,certification, dissemination and other use, filing and review of all documents required under or governed by the Act, the regulations or the rules and alldocuments determined by the regulations or the rules to be ancillary to the documents.
The CSA have not seriously considered any alternatives to the making of the proposed National Instrument. The only alternative methods of achieving theregulatory goals contained in NP39 would be through the amendment of the securities legislation of the various provinces and territories or through the adoptionof a specific mutual funds statute either at the provincial or the federal level. These approaches are not considered to be practical at the present time.20
The proposed National Instrument and Companion Policy are related to each other.
In proposing the National Instrument and Companion Policy, the CSA have not relied on any significant unpublished study, report, decision or other writtenmaterials.
Anticipated Costs and Benefits
Mutual fund issuers and service providers to mutual funds should benefit, over the longer term, from the proposed National Instrument and the CompanionPolicy. The intent of the CSA in preparing the proposed National Instrument is to (i) clarify the mandatory rules applicable to mutual funds and their relatedservice providers and (ii) to update those requirements to reflect current administrative practice and the views of the CSA. For the most part, the proposedNational Instrument does not impose rules on mutual fund issuers and their service providers that are substantially different from those rules and policies underwhich mutual funds and their service providers have historically been governed. Accordingly, the proposed National Instrument and Companion Policy shouldnot impose significantly greater compliance costs than are currently borne by mutual funds and their service providers, and may result in a lessening of thosecosts, assuming the CSA have been successful in their aim to achieve legislative certainty and clarity in the rules. The CSA anticipate that mutual funds and theirservice providers may experience a transition period in which costs are incurred in reviewing and understanding the rules provided for in the proposed NationalInstrument, but that such transition period will not be materially different from the transition period for any rule of the CSA replacing an existing rule or policy ofthe CSA.
Some of the changes from NP39 that are contained in the proposed National Instrument may create some compliance costs for mutual funds and their serviceproviders. For instance, under the proposed National Instrument, a mutual fund will be required to
(a) monitor the ongoing level of its illiquid assets to ensure that it does not breach the ongoing 10 percent restriction;
(b) monitor its exposure to counterparties in derivatives transactions to ensure that it does not breach the new restriction against exposure of more than 10percent of its net assets to a counterparty other than clearing corporations listed in Appendix A to the proposed National Instrument;
(c) consider the effect of the elimination of section 4.03 of NP39 on its trading activities; and
(d) incur costs associated with compliance with the proposed disclosure requirements for "significant changes" to a mutual fund contained in the proposedNational Instrument.
In addition, a money market fund may be required to sustain costs making adjustments to its portfolio in order to continue to fall with the definition of "moneymarket fund" in the proposed National Instrument. Also, certain reorganization transactions and control changes in mutual fund managers that are capable ofbeing completed under NP39 without securityholder approval may require securityholder approval under the proposed National Instrument.
Principal distributors and participating dealers may incur costs related to the removal of the provisions contained in NP39 that permit them to recover amountspaid in connection with failed sales and redemptions of securities of mutual funds.
On the other hand, the CSA expect that certain regulatory costs may be reduced, since the CSA have not brought forward into the proposed National Instrumentrequirements currently provided for in NP39 to seek prior Canadian securities regulatory authorities in respect of a number of matters. For instance, theproposed National Instrument substitutes specific rules for the necessity to seek prior Canadian securities regulatory approvals in respect of in specie purchases,incentive fees, certain prescribed mergers and investments in certain instruments, among other things.
Industry participants and investors in mutual funds should benefit from the modernization of the rules applicable to public mutual funds and from any reduction incosts incurred by mutual fund issuers and their service providers in complying with these rules.
Regulations to be Revoked or Amended
The OSC will request the Lieutenant Governor in Council to revoke sections 33 to 66, and 79-82 of the Regulation in connection with Rule 41-501 GeneralProspectus Requirements. References to NP39 are contained in sections 52 and 81 of the Regulation.
Specific Requests for Comment
In addition to welcoming submissions on any provision proposed in the proposed National Instrument and the Companion Policy, the CSA seek comment on thespecific matters referred to below.
Specific Requests Concerning the Use of Derivatives by Mutual Funds
The CSA have received suggestions that swaps be added to the list of permitted derivatives. The CSA are not opposed in principle to the use of swaps bymutual funds, and note that mutual funds may achieve the economic equivalent of a swap through the use of forward contracts. However, the CSA are of theview that swaps themselves should not be permitted unless appropriate rules governing their use, similar to those contained in section 2.3 of the proposedNational Instrument, are developed. The CSA invite comment about the way in which those rules should be structured.
Subsection 2.3(2) requires mutual funds to hold cash cover in respect of their derivatives positions held for non-hedging purposes. The CSA are proposing toexpand the definition of cash cover from what is contained in NP39 to permit mutual funds to use "synthetic cash" to satisfy cash cover requirements on the basisthat synthetic cash enables a mutual fund to hold the economic equivalent of cash. The definition of synthetic cash included in the proposed National Instrumentarticulates two permissable arrangements that would result in the mutual fund holding the economic equivalent of cash. The CSA seek comment on theappropriateness of permitting synthetic cash to be used as a form of cash cover, on the appropriateness of the proposed definition of synthetic cash, and whetherthe definition should be expanded to include other structures that could be used to create synthetic cash.
Subsection 2.3(6) contains a provision mandating how a synthetic cash position should be quantified for purposes of determining compliance with the cash coverrequirements. Comment is invited on the appropriateness of this provision.
Subsection 2.3(7) imposes a new restriction limiting the aggregate exposure of a mutual fund in permitted derivatives positions to any one counterparty otherthan a clearing corporation listed in Appendix A to the proposed National Instrument. The aggregate marked-to- market value of permitted derivatives positionsheld by a mutual fund with any one such counterparty cannot exceed, for an unbroken period of 30 days or more, more than 10 percent of the net assets of themutual fund. This provision is designed to be analogous to paragraph 2.1(1)(a) of the proposed National Instrument with respect to direct holdings of securities,and protect mutual funds from excessive concentration risk. The CSA invite comment on whether the test should be in respect of an "aggregate"marked-to-market value or a "net" marked-to-market value.
An "index participation unit" in the proposed National Instrument is excluded from the definition of "specified derivative", meaning that mutual funds canpurchase index participation units without regard to the derivatives rules of the Instrument. The definition of "index participation unit" includes only units ofinterest traded on, and sponsored by, a stock exchange in Canada that, in essence, hold securities for the purpose of replicating the performance of the relevantindex. Comment is requested on whether this definition should be expanded to include non-Canadian vehicles of this type and, if so, which vehicles.
Specific Requests Concerning Investment Restrictions and Practices to be followed by Mutual Funds
The proposed National Instrument makes a number of changes to the "illiquid asset" restrictions contained in NP39, as described in this Notice. Comment isspecifically requested on the appropriateness of structuring the illiquid asset restrictions of the proposed National Instrument as both purchase and ongoing tests.The CSA recognize that a mutual fund could breach a 10 percent ongoing test as a result only of market movements. The CSA specifically request comment onwhether the 30 day cure period provided for in the Instrument is the best way of dealing with this issue, or whether an alternative approach could be to impose ahigher restriction, such as 15 percent, for the ongoing test.
Specific Requests Concerning Inter-Fund Trading
Section 4.2 of the proposed National Instrument is substantially similar to subsection 2.05(11) of NP39 and prohibits trades between a mutual fund and aprescribed list of persons or companies. The breadth of these provisions prevent so-called inter-fund trading, which consists of purchases and sales of portfoliosecurities among two or more related mutual funds. The CSA invite comment on whether inter-fund trading should be permitted, and, if so, on what basishaving regard to the conflict concerns associated with these types of transactions.
Specific Requests Concerning Increases in Fees and Expenses
Paragraphs 5.1(a) and section 5.3 operate to ensure that securityholders either approve, or receive 60 days' prior notice of, an increase of fees and expensescharged to a mutual fund, depending on whether the fund is contracting with a party that is at arms' length to it. The CSA have received suggestions that theseprovisions should recognize a de minimus level of increase, so that fee or expense increases below that level will not trigger these requirements. The CSArequest comment generally on this proposal, and specifically on what de minimus threshold would be appropriate and how such a threshold would be structured.
Specific Requests Concerning Changes in Auditors
Certain groups, including the Steering Group21, have recommended that the list of fundamental changes requiring securityholder approvals be amended to deletethe inclusion of "change of auditors" from the list. The CSA continue to believe that a securityholder vote is appropriate in these circumstances in order toensure that securityholders of mutual funds, which are mostly trusts, have the same rights as securityholders of corporations under the corporate statutes.However, the CSA seek comment on whether an alternative regime, such as a CSA-approved list of acceptable auditing firms, would be appropriate.
Specific Requests Concerning Securityholders of Continuing Funds involved in Mergers and other Transactions
Paragraph 5.1(1)(f) of the proposed National Instrument provides that securityholders of a mutual fund that is amalgamated or merged with one or more othermutual funds, or that undertakes a reorganization or transfer of assets, must approve the transaction if the transaction results in the securityholders becomingsecurityholders of another mutual fund. As described above, the CSA believe that this right to vote for securityholders of the "terminating" fund is fundamentalin these circumstances.
The CSA have not required in the proposed National Instrument that such transactions also require the approval of securityholders of the "continuing" fund, andrequest comment on whether that is appropriate in all, or some circumstances. If no vote is deemed necessary, under what circumstances should securityholdersreceive advance notice of an impending transaction involving their mutual fund?
The CSA note that the investment of securityholders of a "continuing" fund could be changed substantially as the result of a merger transaction, as the mutualfund resulting from the transaction could be of substantially different size to the prior funds or the continuing fund could have a substantially higher number ofsecurityholder accounts, leading to higher administrative costs.
The CSA are also concerned with the income tax implications of these transactions to the continuing funds and their securityholders. Most of these transactionsare structured as "qualifying exchanges" under the ITA, and the "pre-approved" merger provisions of the proposed National Instrument require that the mergersbe such. In this way, the assets being transferred from the "terminating" fund (or funds) to the "continuing" fund would receive a roll-over treatment under theITA. As a result, the continuing fund (or its securityholders) would effectively inherit the tax liability, if any, associated with any accrued, but unrealized, capitalgains of assets transferred to it. The CSA recognize the mechanism available for use by mutual funds contained in the ITA which permits a mutual fund torecover, over time, any capital gains taxes paid by it in respect of any realized capital gains. This mechanism minimizes the potential that the securityholders ofthe continuing fund will experience any adverse tax consequences as a result of the inherited unrealized capital gains upon the realization of such capital gains.The CSA request comment on whether mutual funds that have been involved in merger transactions, in fact, manage their operations so as to fully takeadvantage of this capital gains tax refunding mechanism. To the extent that this mechanism is not used, the securityholders of a continuing fund as of the date oftransaction could be subject to a tax liability (depending on when the transferred assets are sold and the length of time those securityholders continue to holdtheir securities in the continuing fund). Have continuing fund securityholders experienced any adverse tax consequences as a result of these transactions? If so,were these consequences significant enough that securityholders of the continuing fund should have voted in respect of the transaction, or at the very least,received notice of the impending transaction?
Specific Requests Concerning Fundamental Changes Made to Mutual Fund Managers
Subsection 5.1(2) contains a new requirement that securityholder approval be obtained before completion of a transaction that results in a change in control of amanager of a mutual fund. As described above, CSA staff have identified several recent transactions that have been structured as a change in control of amanager, but that in reality have resulted in a change in the manager for the mutual funds within the fund family. The CSA have considered a number ofapproaches in dealing with their concern that such transactions should be made only with the approval of the securityholders of the affected funds, and areproposing subsection 5.1(2) as the most direct way of dealing with this issue.
The CSA specifically request comment on this matter and whether alternatives can be identified that still deal with the fundamental issue, being whethersecurityholders should have a say in whether or not fundamental changes to the management of their mutual fund are made.
Specific Requests Concerning Dissenting Securityholders
The CSA have considered the rights of securityholders of a mutual fund who do not agree with a proposed fundamental change to the fund of the nature referredto in section 5.1. The CSA recognize that securityholders who do not agree with, for example, a proposed change in fundamental investment objective or aproposed merger of their fund with another fund have the right to vote against the proposal and always have the right to "vote with their feet" and redeem theirholdings at the current net asset value. However, the CSA are also cognizant that for securityholders that acquired their securities on a "back-end" load basis,redemption may not be in their economic best interests having regard to the deferred sales charges those investors may be liable to pay in respect of aredemption. Securityholders that acquired securities on a "front end" load basis may also be similarly disadvantaged if they redeem. These securityholders paidsales charges in order to acquire a particular mutual fund; when a front end load securityholder does not agree with a proposed fundamental change to the fundand redeems his or her securities these sales charges will not be reimbursed. Accordingly, securityholders may decide to stay in the fund, despite theirfundamental disagreement with the proposal of the manager. The CSA also recognize the somewhat perfunctory nature of securityholder meetings; voterturnout is poor and votes rarely result in disapproval of the proposed action. OSC Commissioner Stromberg discusses the issue of redemption without penaltyin the Stromberg Report and recommends that securityholders be provided with an opportunity to receive a refund of sales charges paid for a limited period. Sherecommended that follow-on work be conducted in this regard.22 The CSA request specific comment on this issue.
Specific Requests Concerning Timing on Failed Redemptions
Subsection 10.5(1) provides that, in cases of failed redemptions, a mutual fund shall reverse the transaction if the requirements of the fund have not been satisfiedon or before the tenth business day after the date of the redemption of the securities. The CSA request comment on whether that 10 day period should beshortened to three days, to conform with the general approach of the proposed National Instrument of recognizing a "T + 3" timing on settlement matters.
Specific Requests Concerning Handling of Money by Dealers
Subsections 11.1(4) and 11.2(4) require all interest earned on trust accounts operated by principal distributors and participating dealers in accordance with Part11 of the proposed National Instrument to be paid at least monthly to the relevant mutual funds. The corresponding sections in NP39 give dealers the option ofpaying over interest to applicable investors. The CSA have been advised that most dealers pay over the interest to the relevant mutual funds, rather than theinvestors, but request comment on whether there is a need to retain the option of paying interest to applicable investors as permitted by NP39.
Specific Requests Concerning Performance Data for "Clone Funds"
The CSA have received inquiries from time to time about the ability of so-called "clone" mutual funds to include in their sales communication performance dataof the mutual funds of which they are "clones", particularly during the period when the "clone" mutual fund does not itself have a performance history. A "clone"mutual fund is a mutual fund that is modelled after, and maintains an investment portfolio very similar to another mutual fund. Typically, a "clone" mutual fundwill be sold in Canada as the direct copy of a successful mutual fund that operates in the United States. Although the CSA recognize why mutual funds wouldlike to report performance data of funds of which they are clones, the CSA have serious concerns about the comparability of performance data of another mutualfund, particularly one operating in a different regulatory and tax environment. The proposed National Instrument does not permit a "young" fund to report itsown performance history; should such a fund be permitted, in effect, to sell itself on the basis of the performance of another mutual fund?
The CSA invite comment on whether a mutual fund should be permitted to disclose performance data about another mutual fund of which it is a clone andwhether it is appropriate for this information to be given during the start-up phase of the fund in question.
Interested parties are invited to make written submissions with respect to the proposed National Instrument. Submissions received by October 31, 1997 will beconsidered.
Submissions should be sent to all of the Canadian securities regulatory authorities listed below in care of the Ontario Commission, in duplicate, as indicatedbelow:
British Columbia Securities Commission
Alberta Securities Commission
Saskatchewan Securities Commission
The Manitoba Securities Commission
Ontario Securities Commission
Office of the Administrator, New Brunswick
Registrar of Securities, Prince Edward Island
Nova Scotia Securities Commission
Securities Commission of Newfoundland
Securities Registry, Government of the Northwest Territories
Registrar of Securities, Government of the Yukon Territory
c/o Daniel P. Iggers, Secretary
Ontario Securities Commission
20 Queen Street West
Suite 800, Box 55
Toronto, Ontario M5H 3S8
Submissions should also be addressed to the Commission
des valeurs mobilières du Québec as follows:
Jacques Labelle, General Secretary
Commission des valeurs mobilières du Québec
800 Victoria Square
Stock Exchange Tower
P.O. Box 246, 17th Floor
Montréal, Québec H4Z 1G3
A diskette containing the submissions (in DOS or Windows format,
preferably WordPerfect) should also be submitted. As securities
legislation in certain provinces requires that a summary of written
comments received during the comment period be published,
confidentiality of submissions cannot be maintained.
Questions may be referred to any of:
Senior Policy Advisor, Policy & Legislation
British Columbia Securities Commission
Alberta Securities Commission
Rebecca A. Cowdery
Special Counsel, Market Operations
Ontario Securities Commission
Legal Counsel, Service de la réglementation
Commission des valeurs mobilières du Québec
Text of Proposed Rescission of National Policy Statement No. 34 and National Policy Statement No. 39
National Policy Statement No. 34 and National Policy Statement No. 39 are to be replaced by the proposed National Instrument and accordingly will berescinded.
The text of the proposed rescission of National Policy Statement No. 34 is:
"National Policy Statement No. 34, entitled "Unincorporated Issuers: Requirement to Maintain a Register of Security Holders", is rescinded."
The text of the proposed rescission of National Policy Statement No. 39 is:
"National Policy Statement No. 39, entitled "Mutual Funds", is rescinded."
Proposed National Instrument and Companion Policy
The text of the proposed National Instrument and Companion Policy follow, together with footnotes that are not part of the proposed National Instrument orCompanion Policy, but have been included to provide background and explanation.
DATED: June 27, 1997.
SUMMARY OF MAJOR CHANGES MADE IN NI 81-102
FROM NATIONAL POLICY STATEMENT NO. 39
THE CHART SUMMARIZING THE MAJOR CHANGES MADE IN NI 81-102 FROM NATIONAL POLICY STATEMENT NO. 39 WASPUBLISHED IN THE OSC BULLETIN, JUNE 27, 1997 (20 OSCB ISSUE 26 (SUPP-3))