Securities Bulletin - mcmillan.ca

1 Securities Bulletin November 2016 Introducing Liquid Alternatives: Game changer for Canadian hedge funds On September 22, 2016, the Canadian Securities Administrators (the CSA ) published their long-awaited proposal for a liquid alternatives regulatory framework in Canada (the Proposal ). The Proposal primarily involves amendments to the rules contained in National Instrument 81-102 Investment Funds ( NI 81-102 ) currently applicable to conventional mutual funds and non-redeemable investment funds. The new framework would create a new category of prospectus offered investment funds called alternative funds that would be able to use investment strategies that are not permitted to be used by conventional mutual funds.

2 Currently, alternative strategies are generally only available through private pooled funds offered under offering memorandums to accredited investors and other exempt purchasers. The Proposal has the potential to advance a significant change in the industry, as alternative funds would be able to distribute their Securities on a continuous basis to retail investors under a simplified prospectus. The Proposal also eliminates National Instrument 81-104 Commodity Pools ( NI 81-104 ), currently applicable to publicly offered commodity pools, and subsumes that regime into the new category of alternative funds in NI 81-102. The proposed amendments recognize that the commodity pool rules have McMillan LLP Brookfield Place, 181 Bay Street, Suite 4400, Toronto, Ontario, Canada M5J 2T3 Vancouver Calgary Toronto Ottawa Montr al Hong Kong Page 2 generally not been used for funds that are commodity pools in the traditional sense.

3 Rather, many commodity pools that operate under NI 81-104 employ derivative strategies not permitted to be used by conventional mutual funds under NI 81-102. The Proposal also modifies certain investment restrictions for both conventional mutual funds and non-redeemable investment funds or closed-end funds. These changes were considered to be interrelated with the alterative funds framework. In many cases, the new investment restrictions introduced for alternative funds are also being imposed on closed-end funds where such restrictions do not currently exist. Background The Proposal is part of the CSA s broader project over the past few years to modernize investment fund product regulation.

4 In 2012, Phase 1 of the modernization project codified certain exemptive relief that had frequently been granted to publicly offered mutual funds in recognition of market and product developments. In 2014, Phase 2 of the project introduced core investment restrictions and fundamental operational requirements for closed-end funds and enhanced disclosure requirements for all investment funds regarding Securities lending activities. The Proposal represents the last part of Phase 2 and the final stage of the CSA s modernization project. The CSA first published an outline of a proposed regulatory framework for alternative funds over three years ago.

5 Two years later, in February 2015, they published a summary of the feedback received and noted that publication of the proposed amendments would follow in due course. Following some delays, the Proposal is finally here, with the CSA seeking comments on a number of questions by December 22, 2016. Summary of the Alternative Funds Proposal The following is a summary of the principal characteristics and restrictions of the alternative funds framework under the Proposal: McMillan LLP Page 3 Naming and definition of an Alternative Fund The name of an alternative fund is not required to contain the word alternative or any other word signalling that the fund is an alternative fund under NI 81-102.

6 An alternative fund is defined as a mutual fund that has adopted fundamental investment objectives that permit it to invest in asset classes or adopt investment strategies that are otherwise prohibited but for prescribed exemptions from Part 2 of NI 81-102. The definition of alternative fund is similar to the current definition of commodity pool in NI 81-104, which is a mutual fund, other than a precious metals fund, that has adopted fundamental investment objectives that permit it to use or invest in (a) specified derivatives in a manner that is not permitted by NI 81-102, or (b) physical commodities in a manner that is not permitted by NI 81-102.

7 Concentration Investments by alternative funds in any one issuer can be no more than 20% of net asset value (NAV) of the fund at the time of purchase (in comparison to 10% for conventional mutual funds). This 20% concentration limit does not apply to the purchase of certain Securities ,1 including government Securities . Closed-end funds, which currently have no concentration restrictions, would also be subject to this 20% limit under the Proposal. Physical commodities Alternative funds would be exempt from any restrictions relating to investments in physical commodities. Closed-end funds would also continue to be exempt from such restrictions.

8 1 Section (2) of NI 81-102 states that the 20% concentration limit does not apply to the purchase of any of the following: (a) a government security; (b) a security issued by a clearing corporation; (c) a security issued by an investment fund if the purchase is made in accordance with the requirements of section of NI 81-102; (d) an index participation unit that is a security of an investment fund; and (e) an equity security if the purchase is made by a fixed portfolio investment fund in accordance with its investment objectives. McMillan LLP Page 4 Under the proposal, conventional mutual funds, which are currently restricted to investing in gold, would be permitted to directly invest in gold, silver, palladium and platinum as well as to obtain indirect exposure to any physical commodity through specified derivatives.

9 Illiquid assets Investments in illiquid assets are limited to 10% of NAV after purchase and 15% of NAV at any time. This same rule currently applies to conventional mutual funds. The CSA recognizes that certain types of alternative funds may wish to hold a larger percentage of their portfolio in illiquid assets (and consequently offer less frequent redemptions) and is seeking feedback on whether a higher illiquid asset limit would be appropriate in such circumstances. The Proposal also introduces different illiquidity restrictions for closed-end funds, which currently have no such restrictions. Under the Proposal, illiquid assets of closed-en d fund would be limited to 20% of NAV after purchase and 25% of NAV at any time.

10 This may be a significant change for some funds that have a particular focus on illiquid assets. The Proposal makes no substantive change to the definition of illiquid assets ,2 which may not capture certain assets that may be of interest to alternative fund managers. Borrowing Alternative funds can borrow up to an amount equal to 50% of their NAV. Although, they may only borrow from entities that qualify as investment fund custodians under section of NI 81-102, which essentially restricts borrowing to banks and trust 2 Under the Proposal, illiquid asset means (a) a portfolio asset that cannot be readily disposed of through market facilities on which public quotations in common use are widely available at an amount that at least approximates the amount at which the portfolio asset is valued in calculating the net asset value per security of the investment fund, or (b) a restricted security held by an investment fund.