National Bank Investments Inc.
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – relief from sections 2.7(1), 2.7(4) and 6.1(1) of National Instrument 81-102 Investment Fundsto permit mutual funds to enter into swap transactions that are cleared through a clearing corporation, subject to certain conditions – relief required because of new U.S. and European requirements to clear over-the-counter derivatives including swaps – relief from sections 2.8(1)(d) and 2.8(1)(f)(i) of National Instrument 81-102 to permit mutual funds that open or maintain a long position in a standardized future or forward contract or enter into or maintain a swap position and during the periods when the funds are entitled to receive payments under the swap, to use as cover, a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap, subject to certain conditions – relief from section 2.1(1) of National Instrument 81-102 to permit global fixed income mutual funds to invest more than 10% of net asset value in debt securities issued by a foreign government or permitted supranational agency, subject to certain conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.1(1) 2.7(1), 2.7(4), 2.8(1)(d), 2.8(1)(f)(i), 6.1(1), 19.1.
[Translation]
November 11, 2016
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
QUÉBEC AND ONTARIO
(the Jurisdictions)
AND
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS
IN MULTIPLE JURISDICTIONS
AND
IN THE MATTER OF
NATIONAL BANK INVESTMENTS INC.
(the Filer)
DECISION
Background
The securities regulatory authority or regulator in each of the Jurisdictions (Decision Maker) has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation), pursuant to section 19.1 of Regulation 81-102 respecting Investment Funds (c. V-1.1, r.39) (Regulation 81-102), exempting the NB Funds (as defined below), as specified below:
(a) with respect to each NB Fund that enters into Cleared Swaps (as defined below):
(i) from the requirement in subsection 2.7(1) of Regulation 81-102 that a mutual fund must not purchase an option or a debt-like security or enter into a swap or a forward contract unless, at the time of the transaction (A) the option, debt-like security, swap or contract has a designated rating or (B) the equivalent debt of the counterparty, or of a person or company that has fully and unconditionally guaranteed the obligations of the counterparty in respect of the option, debt-like security, swap or contract, has a designated rating;
(ii) from the limitation in subsection 2.7(4) of Regulation 81-102 that the marktomarket value of the exposure of a mutual fund under its specified derivatives positions with any one counterparty other than an acceptable clearing corporation or a clearing corporation that clears and settles transactions made on a futures exchange listed in Appendix A to Regulation 81-102 shall not exceed, for a period of 30 days or more, 10% of the net asset value of the mutual fund; and
(iii) from the requirement in subsection 6.1(1) of Regulation 81-102 to hold all portfolio assets of an investment fund under the custodianship of one custodian in order to permit each NB Fund to deposit cash and other portfolio assets directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) as margin,
(collectively, the Cleared Swaps Relief);
(b) with respect to each NB Fund, from the cover requirement in paragraph 2.8(1)(d) and subparagraph 2.8(1)(f)(i) of Regulation 81-102 in order to permit each of the NB Funds to use as cover a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap when it:
(i) opens or maintains a long position in a debt-like security that has a component that is a long position in a forward contract or in a standardized future or forward contract; or
(ii) enters into or maintains a swap position and during the periods when the NB Fund is entitled to receive payments under the swap,
(collectively, the Derivative Cover Relief); and
(c) with respect to each NB Bond Fund (as defined below), from the concentration restriction of subsection 2.1(1) of Regulation 81-102 in order to permit each NB Bond Fund to invest up to:
(i) 20% of its net asset value at the time of the transaction in evidences of indebtedness of any one issuer if those evidences of indebtedness are issued, or guaranteed fully as to principal and interest, by supranational agencies or governments other than the government of Canada, the government of a jurisdiction in Canada or the government of the United States of America and are rated “AA” by Standard & Poor’s Rating Services (Canada) (S&P) or its DRO affiliate or have an equivalent rating by one or more other designated rating organizations or their DRO affiliates; and
(ii) 35% of its net asset value at the time of the transaction in evidences of indebtedness of any one issuer if those securities are issued, or guaranteed fully as to principal and interest, by supranational agencies or governments other than the government of Canada, the government of a jurisdiction in Canada or the government of the United States of America and are rated “AAA” by S&P or its DRO affiliate, or have an equivalent rating by one or more other designated rating organizations or their DRO affiliates (the evidences of indebtedness in (i) and (ii), collectively, Foreign Government Securities),
(collectively, the Sovereign Government and Supranational Entity Concentration Relief).
The Cleared Swaps Relief, the Derivative Cover Relief and the Sovereign Government and Supranational Entity Concentration Relief are, collectively, the Exemptions Sought.
The Filer has also applied to revoke the Previous Cleared Swaps Relief (as defined below) (the Revocation).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a dual application):
(a) the Autorité des marchés financiers is the principal regulator for this application;
(b) the Filer has provided notice that subsection 4.7(1) of Regulation 11-102 respecting Passport System (c. V-1.1, r.1) (Regulation 11-102) is intended to be relied upon in the jurisdictions of Canada other than the Jurisdictions; and
(c) the decision is the decision of the principal regulator and evidences the decision of the securities regulatory authority or regulator in Ontario.
Interpretation
Terms defined in Regulation 81-102, Regulation 14-101 respecting Definitions (c. V-1.1, r.3) and Regulation 11-102 have the same meaning if used in this decision, unless otherwise defined. Capitalized terms used in this decision have the following meanings:
CFTC means the U.S. Commodity Futures Trading Commission
Cleared Swap means any OTC derivative transaction that can be entered into on a cleared basis, whether or not such derivative is subject to a clearing determination or a clearing obligation issued by the CFTC or ESMA, as the case may be
Clearing Corporation means any clearing organization registered with the CFTC or central counterparty authorized by ESMA, as the case may be, that, in either case, is also recognized or exempt from recognition in a Jurisdiction, as the case may be, where the NB fund is located
Dodd-Frank means the Dodd-Frank Wall Street Reform and Consumer Protection Act
EMIR means the European Market Infrastructure Regulation
ESMA means the European Securities and Markets Authority
Existing NB Funds means the NB Funds that are relying on the Previous Cleared Swaps Relief as at the date of this decision
Futures Commission Merchant means any futures commission merchant that is registered with the CFTC and/or clearing member for purposes of EMIR, as applicable, and is a member of a Clearing Corporation
NB Bond Funds means National Bank Global Tactical Bond Fund, National Bank U.S. $ Global Tactical Bond Fund and NBI Unconstrained Fixed Income Fund
NB Funds means (i) the Existing NB Funds, (ii) the NB Bond Funds, and (iii) as applicable, all other current and future mutual funds managed by the Filer that are subject to Regulation 81-102
OTC means over-the-counter
Portfolio Manager means each portfolio manager retained from time to time by the Filer to manage the investment portfolio of one or more NB Funds
Previous Cleared Swaps Relief means the relief granted to the Existing NB Funds pursuant to a decision document dated December 3, 2014 from the requirements in subsections 2.7(1), 2.7(4) and 6.1(1) of Regulation 81-102 to permit the Existing NB Funds to enter into cleared swaps that are, or will be, subject to a clearing determination issued by the CFTC
Representations
This decision is based on the following facts represented by the Filer:
The Filer and the NB Funds
1. The Filer is, or will be, the investment fund manager of each NB Fund. The Filer is registered as an investment fund manager in each of the Provinces of Québec, Ontario and Newfoundland and Labrador and as a mutual fund dealer in each of the jurisdictions of Canada. The head office of the Filer is in Montreal, Québec.
2. Each NB Fund is, or will be, a mutual fund created under the laws of the Province of Ontario or under the laws of the Province of Québec and is, or will be, subject to the provisions of Regulation 81-102.
3. The securities of each NB Fund are, or will be, qualified for distribution pursuant to a prospectus that was, or will be, prepared and filed in accordance with the securities legislation of the jurisdictions of Canada. Accordingly, each NB Fund is, or will be, a reporting issuer or the equivalent in the jurisdictions of Canada.
4. Neither the Filer nor the NB Funds in existence as of the date hereof are in default of securities legislation in any jurisdiction of Canada.
Previous Cleared Swaps Relief
5. The Previous Cleared Swaps Relief, in accordance with its terms, terminates on December 3, 2016.
6. The Filer is seeking the Cleared Swaps Relief in order to revoke the Previous Cleared Swaps Relief and to permit NB Funds to also enter into Cleared Swaps.
Reasons supporting the Cleared Swaps Relief
7. The investment objective and investment strategies of each NB Fund that enters into, or will enter into, Cleared Swaps permit, or will permit, the NB Fund to enter into derivative transactions, including Cleared Swaps.
8. Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a Clearing Corporation.
9. EMIR also requires that certain OTC derivatives be cleared through a central counterparty authorized to provide clearing services for purposes of EMIR.
10. In addition to clearing swaps that are mandated to be cleared under Dodd-Frank and/or EMIR, many of the Clearing Corporations offer clearing services in respect of other types of derivative transactions. Many global derivative end-users enter into Cleared Swaps on both a voluntary and a mandatory basis.
11. In the absence of the Cleared Swaps Relief, each Portfolio Manager will need to structure the derivative transactions entered into by the applicable NB Funds so as to avoid clearing, including the clearing requirements of the CFTC and under EMIR, as applicable. The Filer respectfully submits that this would not be in the best interests of the NB Funds and their securityholders for a number of reasons, as set out below.
12. The Filer wishes that the NB Funds have the ability to enter into Cleared Swaps in order to benefit from the pricing benefits and reduced trading costs that each Portfolio Manager is often able to achieve through its trade execution practices and from the reduced costs associated with Cleared Swaps as compared to other OTC trades.
13. A Portfolio Manager may use common trade execution practices for all of its accounts, including the NB Funds. If these practices involve the use of Cleared Swaps and if the NB Funds are unable to employ these trade execution practices, then the Portfolio Manager would have to create separate trade execution practices only for the NB Funds and would have to execute trade for the NB Funds on a separate basis. This would increase the operational risk for the NB Funds and would prevent the NB Funds from benefitting from the pricing benefits and reduced trading costs that a Portfolio Manager may be able to achieve through common practices for its advised accounts. In the Filer’s opinion, best execution and maximum certainty can best be achieved through common trade execution practices, which, in the case of OTC derivatives, involve the execution of Cleared Swaps.
14. In accordance with the Filer’s standard of care owed to the NB Funds pursuant to applicable legislation, the Filer has determined that central clearing represents the best choice for the securityholders of the NB Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
15. As a member of the G20 and a participant in the September 2009 commitment of G20 nations to improve transparency and mitigate risk in derivatives markets, Canada has expressly recognized the systemic benefits that clearing OTC derivatives offers to market participants, such as the NB Funds. The Filer respectfully submits that the NB Funds should be encouraged to comply with the robust clearing requirements established by the CFTC and under EMIR by granting them the Cleared Swaps Relief.
16. The Cleared Swaps Relief is analogous to the treatment currently afforded under Regulation 81-102 to other types of derivatives that are cleared, i.e., clearing corporation options, options on futures and standardized futures. This demonstrates that, from a policy perspective, such Cleared Swaps Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.
Reasons supporting the Derivative Cover Relief
17. Paragraph 2.8(1)(d) and subparagraph 2.8(1)(f)(i) of Regulation 81-102 do not permit covering a long position in a standardized future or forward contract or a position in a swap for a period when a mutual fund is entitled to receive payments under the swap, in whole or in part with a right or obligation to sell an equivalent quantity of the underlying interest of the future, forward or swap. Accordingly, these provisions of Regulation 81-102 do not permit the use of put options or short future, forward or swap positions to cover long future, forward or swap positions.
18. By not recognizing the hedging properties of options for long positions evidenced by standardized futures or forwards or in respect of swaps where a mutual fund is entitled to receive payments from the counterparty, Regulation 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the mutual fund under this scenario is equal to the difference between the market value of the long position and the exercise price of the option. Overcollateralization imposes a cost on a mutual fund.
19. Paragraph 2.8(1)(c) of Regulation 81-102 permits a mutual fund to write a put option and cover it with buying a right or obligation to sell an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a debt-like security that has a component that has a long position in a forward or a standardized future or forward contract as contemplated by paragraph 2.8(1)(d) or a swap as contemplated by subparagraph 2.8(1)(f)(i) and therefore, the Filer submits that the NB Funds should be permitted to cover a long position in a future, forward or swap with a put option or an offsetting short position.
20. The Filer submits that the Derivative Cover Relief would enable the NB Funds to more effectively manage any exposure they may have under specified derivatives and to have the flexibility to enhance yield.
Reasons supporting the Sovereign Government and Supranational Entity Concentration Relief
21. The investment objective of National Bank Global Tactical Bond Fund is to generate income and capital growth, while focusing on capital preservation. To achieve its investment objective, National Bank Global Tactical Bond Fund invests directly, or indirectly through investments in securities of other mutual funds or through the use of derivatives, in a diverse portfolio mainly composed of bonds and other foreign fixedincome securities with various maturities and credit ratings.
22. The investment objective of National Bank U.S. $ Global Tactical Bond Fund is to generate U.S. dollar income and capital growth while focusing on capital preservation. To achieve its investment objective, National Bank U.S. $ Global Tactical Bond Fund invests directly, or indirectly through investments in securities of other mutual funds or through the use of derivatives, in a diversified portfolio mainly composed of foreign bonds and other fixed-income securities with various maturities and credit ratings.
23. The NBI Unconstrained Fixed Income Fund filed a preliminary prospectus on October 17, 2016 and its proposed investment objective is to maximize total return, consistent with preservation of capital. To achieve its investment objective, NBI Unconstrained Fixed Income Fund invests, directly or indirectly through investments in securities of other mutual funds or through the use of derivatives, in a diversified portfolio composed mainly of fixed-income securities of foreign issuers with various maturities and credit ratings.
24. As part of the investment strategies of each NB Bond Fund, each applicable Portfolio Manager would like to invest a portion of the NB Bond Fund’s assets in Foreign Government Securities. Depending on market conditions, the NB Bond Fund’s Portfolio Manager seeks the discretion to gain exposure to any one issuer of Foreign Government Securities in excess of the concentration restriction under subsection 2.1(1) of Regulation 81-102
25. Subsection 2.1(1) of Regulation 81-102 prohibits a NB Bond Fund from purchasing a security of an issuer, other than a “government security” as defined in Regulation 81-102, if, immediately after the purchase, more than 10% of the net asset value of the NB Bond Fund would be invested in securities of the issuer.
26. The Foreign Government Securities do not meet the definition of “government securities”, as such term is defined in Regulation 81-102.
27. In Policy Statement to Regulation 81-102, the Canadian Securities Administrators state their views on various matters relating to Regulation 81-102. Subsection 3.1(4) of the Policy Statement to Regulation 81-102 indicates that relief from paragraph 2.04(1)(a) of National Policy Statement No. 39, which was replaced by section 2.1 of Regulation 81-102, has been provided to mutual funds generally under the following circumstances:
(i) the mutual fund has been permitted to invest up to 20% of its net asset value in evidences of indebtedness of any one issuer if those evidences of indebtedness are issued, or guaranteed fully as to principal and interest, by supranational agencies or governments other than the government of Canada, the government of a jurisdiction or the government of the United States of America and are rated “AA” by S&P or its DRO affiliate, or have an equivalent rating by one or more other designated rating organizations or their DRO affiliates; and
(ii) the mutual fund has been permitted to invest up to 35% of its net asset value in evidences of indebtedness of any one issuer, if those securities are issued, or fully guaranteed as to principal and interest, by supranational agencies or governments other than the government of Canada, the government of a jurisdiction, or the government of the United States of America and are rated “AAA” by S&P or its DRO affiliate, or have an equivalent rating by one or more other designated rating organizations or their DRO affiliates.
28. The Filer believes that the Sovereign Government and Supranational Entity Concentration Relief will better enable each NB Bond Fund to achieve its fundamental investment objective.
29. For the reasons provided above, the Filer submits that it would not be detrimental to the protection of investors to grant the Exemptions Sought to the NB Funds.
Decision
Each of the Decision Makers is satisfied that the decision meets the test set out in the Legislation for the Decision Maker to make the decision.
The decision of the Decision Makers under the Legislation is that the Revocation is granted and the Exemptions Sought are granted provided that:
1. in the case of the Cleared Swaps Relief, when any rules applicable to customer clearing of OTC derivatives enter into force, the Clearing Corporation is permitted to offer customer clearing of OTC derivatives in the Jurisdiction, as the case may be, where the applicable NB Fund is located and provided further that, in respect of the deposit of cash and other portfolio assets as margin:
(a) in Canada,
(i) the Futures Commission Merchant is a member of a SRO that is a participating member of CIPF; and
(ii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10% of the net asset value of the NB Fund as at the time of deposit; and
(b) outside of Canada,
(i) the Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to a regulatory audit;
(ii) the Futures Commission Merchant has a net worth, determined from its most recent audited financial statements that have been made public or from other publicly available financial information, in excess of the equivalent of $50 million; and
(iii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10% of the net asset value of the NB Fund as at the time of deposit;
2. in the case of the Derivative Cover Relief:
(a) when a NB Fund enters into or maintains a swap position for periods when the NB Fund would be entitled to receive fixed payments under the swap, the NB Fund holds:
(i) cash cover in an amount that, together with margin on account for the swap and the market value of the swap, is not less than, on a daily markto-market basis, the underlying market exposure of the swap;
(ii) a right or obligation to enter into an offsetting swap on an equivalent quantity and with an equivalent term and cash cover that together with margin on account for the position is not less than the aggregate amount, if any, of the obligations of the NB Fund under the swap less the obligations of the NB Fund under such offsetting swap; or
(iii) a combination of the positions referred to in clauses (i) and (ii) that is sufficient, without recourse to other assets of the NB Fund, to enable the NB Fund to satisfy its obligations under the swap;
(b) when a NB Fund opens or maintains a long position in a debt-like security that has a component that is a long position in a forward contract, or in a standardized future or forward contract, the NB Fund holds:
(i) cash cover in an amount that, together with margin on account for the specified derivative and the market value of the specified derivative, is not less than, on a daily mark-to-market basis, the underlying market exposure of the specified derivative;
(ii) a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and cash cover that together with margin on account for the position, is not less than the aggregate amount, if any, by which the price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest; or
(iii) a combination of the positions referred to in clauses (i) and (ii) that is sufficient, without recourse to other assets of the NB Fund, to enable the NB Fund to satisfy its obligations under the future or forward contact; and
(c) a NB Fund will not (i) purchase a debt-like security that has an option component or an option, or (ii) purchase or write an option to cover any positions under paragraphs 2.8(1)(b), (c), (d), (e) and (f) of Regulation 81-102, if immediately after the purchase or writing of such option, more than 10% of the net asset value of the NB Fund, taken at market value at the time of the transaction, would be in the form of (1) purchased debt-like securities that have an option component or purchased options, in each case, held by the NB Fund for purposes other than hedging, or (2) options used to cover any positions under paragraphs 2.8(1)(b), (c), (d), (e) and (f) of Regulation 81-102;
3. in the case of the Sovereign Government and Supranational Entity Concentration Relief:
(a) sub-paragraphs (i) and (ii) of the Sovereign Government and Supranational Entity Concentration Relief cannot be combined for any one issuer;
(b) any security that may be purchased by the NB Bond Funds pursuant to the Sovereign Government and Supranational Entity Concentration Relief is traded on a mature and liquid market;
(c) the acquisition of the securities purchased pursuant to this decision is consistent with the fundamental investment objective of each NB Bond Fund;
(d) the simplified prospectus of the NB Bond Funds will disclose the additional risks associated with the concentration of net asset value of a fund in securities of fewer issuers, such as the potential additional exposure to the risk of default of the issuer in which the fund has so invested and the risks, including foreign exchange risks, of investing in the country in which the issuer is located; and
(e) the simplified prospectus of the NB Bond Funds will include a summary of the nature and terms of the Sovereign Government and Supranational Entity Concentration Relief along with the conditions imposed and the type of securities covered by this decision.
This decision with respect to the Cleared Swaps Relief will terminate on the coming into force of any revisions to the provisions of Regulation 81-102 that address the clearing of OTC derivatives.
“Hugo Lacroix”
Senior Director, Investment Funds
Autorité des marchés financiers