Canoe Financial LP
Headnote
National Policy 11-203 Process for Exemptive Relief Applications -- exemption from section 2.8(1) of National Instrument 81-102 Mutual funds to permit mutual funds to cover specified derivatives positions with any bonds, debentures, notes, including floating rate notes, and money market fund securities subject to conditions -- the relief will enhance returns to investors while still providing adequate safeguards.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.8(1), 19.1.
February 17, 2011
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
ALBERTA AND ONTARIO
(the Jurisdictions)
AND
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF
APPLICATIONS IN MULTIPLE JURISDICTIONS
AND
IN THE MATTER OF
CANOE FINANCIAL LP
(the Filer)
DECISION
Background
The securities regulatory authority or regulator in each of the Jurisdictions (the Decision Maker) has received an application from the Filer for a decision on behalf of the mutual funds listed on Appendix A attached hereto (each, a Prelim Fund and collectively, the Prelim Funds) and any future mutual funds to be managed by the Filer that will be subject to National Instrument 81-102 Mutual Funds (NI 81-102) (the Future Funds, and together with the Prelim Funds, the Funds and individually, a Fund) under the securities legislation of the Jurisdictions (the Legislation) for a decision exempting the Funds from the requirements in:
(a) section 2.8(1) of NI 81-102 to the extent that cash cover is required in respect of specified derivatives to permit each of the Funds to cover specified derivative positions with:
(i) any bonds, debentures, notes, collateralized mortgage backed securities, asset backed securities or other evidences of indebtedness that are liquid (Fixed Income Securities), provided they have a remaining term to maturity of 365 days or less and have an "approved credit rating" a such term is defined in NI 81-102;
(ii) floating rate evidences of indebtedness (Floating Rate Securities); or
(iii) securities of money market funds as defined in NI 81-102 (Money Market Securities); and
(b) sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 to permit the Funds when:
(i) they open or maintain 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) they 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, (relief from the requirements described in paragraphs (a) and (b) above are collectively referred to as the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a dual application):
(a) the Alberta Securities Commission is the principal regulator for this application;
(b) the Filer has provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon by the Filer in each of the provinces and territories of Canada other than Ontario; and
(c) the decision is the decision of the principal regulator and evidences the decision of the securities regulatory authority or regulator in the Province of Ontario.
Interpretation
Terms defined in National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
Representations
This decision is based on the following facts represented by the Filer.
1. The Filer is a limited partnership established under the laws of the Province of Alberta having its registered head office in Calgary, Alberta. The general partner of the Filer is Canoe Financial Corp., a corporation incorporated under the laws of the Province of Alberta. The Filer is registered as an investment fund manager and portfolio manager with the Alberta Securities Commission.
2. The Prelim Funds are each a class of special shares of Canoe 'GO CANADA!' Fund Corp., a mutual fund corporation incorporated under the laws of the Province of Alberta. All the Funds will either be a class of shares of a mutual fund corporation or a mutual fund trust established under the laws of a jurisdiction in Canada.
3. The Filer is the manager and portfolio manager for each of the Prelim Funds and will be the manager and portfolio manager of each Future Fund.
4. A simplified prospectus in respect of the Prelim Funds was filed and a receipt obtained on February 14, 2011. As a result, each Prelim Fund is a "reporting issuer" or equivalent in each province and territory of Canada.
5. Each Fund will be qualified for distribution in each of the provinces and territories of Canada under a simplified prospectus and annual information form. The Funds will be reporting issuers in each of the provinces and territories of Canada.
6. Each of the Filer and the Prelim Funds is not, in default of any requirements of securities legislation in any jurisdiction.
7. The Prelim Funds and many of the Future Funds will use specified derivatives as part of their investment strategies to gain or reduce exposure to securities and financial markets instead of investing in the securities directly. The Funds may also use derivative instruments to: (i) reduce risk by protecting the Funds against potential losses from changes in interest rates; (ii) to reduce the impact of currency fluctuations on the Funds' portfolio holdings; and (iii) to provide protection for the Funds' portfolios.
8. When specified derivatives are used for non-hedging purposes, the Funds are subject to the cash cover requirements in NI 81-102.
Cash Cover
9. The purpose of the cash cover requirement in NI 81-102 is to prohibit a mutual fund from leveraging its assets when using certain specified derivatives and to ensure that the mutual fund is in a position to meet its obligations on the settlement date. This is evident from the definition of "cash cover", which is defined as certain specific portfolio assets of the mutual fund that have not been allocated for specific purposes and that are available to satisfy all or part of the obligations arising from a position in specified derivatives held by the mutual fund. Currently, the definition of "cash cover" includes six different categories of securities, including certain evidences of indebtedness (cash equivalents and commercial paper) that generally have a remaining term to maturity of 365 days or less and that have an approved credit rating or are issued or guaranteed by an entity with an approved credit rating (collectively, short-term debt).
10. In addition to the securities currently included in the definition of cash cover, the Funds would also like to invest in Fixed Income Securities, Floating Rate Securities and/or Money Market Securities for purposes of satisfying their cash cover requirements.
With Respect to Fixed Income Securities:
11. While the money market instruments that are currently permitted as cash cover are highly liquid, these instruments typically generate very low yields relative to longer dated instruments and similar risk alternatives.
12. Other fixed income instruments with maturities less than 365 days and approved credit ratings are also liquid but provide the potential for higher yields.
13. The definition of cash cover addresses regulatory concerns of interest rate risk and credit risk by limiting the terms of the instruments and requiring the instruments to have an approved credit rating. It is submitted that by permitting the Funds to use for cash cover purposes Fixed Income Securities with a remaining term to maturity of 365 days or less and an approved credit rating, the regulatory concerns would be met, since the term and credit rating will be the same as other instruments currently permitted to be used as cash cover.
With Respect to Floating Rate Securities:
14. Floating Rate Securities are debt securities issued by the federal or provincial governments, the Crown or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days. Although the term to maturity of Floating Rate Securities can be more than 365 days, the Funds propose to limit their investment in Floating Rate Securities used for cash cover purposes to those that have interest rates that reset at least every 185 days.
15. Allowing the Funds to use Floating Rate Securities for cash cover purposes could increase the rate of return earned by each of the Fund's investors without reducing the credit quality of the instruments held as cash cover. The frequent interest rate resets mitigate the risk of investing in Floating Rate Securities as cash cover. For the purposes of money market funds under NI 81-102 meeting the 90-days dollar-weighted average term to maturity, the term of floating rate evidence of indebtedness for purposes is the period remaining to the date of the next rate setting. If a Floating Rate Security resets every 365 days, then the interest rate of the Floating Rate Security is about the same as a fixed rate instrument with a term to maturity of 365 days.
16. Financial instruments that meet the current cash cover requirements have low credit risk. The current cash cover requirements provide that evidences of indebtedness of issuers, other than government agencies, must have approved credit ratings. As a result, if the issuer of Floating Rate Securities is an entity other than a government agency, the Floating Rate Securities used by the Funds for cash cover purposes will have an approved credit rating as required by NI 81-102.
17. Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of Floating Rate Securities, the risk profile and the other characteristics of Floating Rate Securities are similar to those of short-term debt, which constitute cash cover under NI 81-102.
Money Market Funds
18. Under NI 81-102, in order to qualify as money market funds, issuers of Money Market Securities are restricted to investments that are, essentially, considered to be cash cover. These investments include floating rate evidences of indebtedness (also known as floating rate notes or FRNs) if their principal amounts continue to have a market value of approximately par at the time of each change in the rate to be paid to their holders.
19. If the direct investments of the issuers of Money Market Securities would constitute cash cover under NI 81-102 (assuming that the relief allowing Floating Rate Securities as cash cover is granted), then it is submitted that indirectly holding these investments through an investment in Money Market Securities should also satisfy the cash cover requirements of NI 81-102.
Using Put Options or Short Positions as Cover for Long Positions in Futures, Forwards and Swaps
20. Sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 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 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 sections of NI 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.
21. Regulatory regimes in other countries recognize the hedging properties of options for all categories of derivatives, including long positions evidenced by standardized futures or forwards or in respect of swaps where a fund is entitled to receive payments from the counterparty, provided they are covered by an amount equal to the difference between the market price of a holding and the strike price of the option that was bought or sold to hedge it. NI 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the fund under the scenario described is equal to the difference between the market value of the long and the exercise price of the option. Overcollateralization imposes a cost on a mutual fund.
22. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with buying a put option on an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a long position in a future, forward or swap. Accordingly, it is submitted that the Funds be permitted to cover a long position in a future, forward or swap with a put option or short future, forward or swap position.
Derivative Policies and Risk Management
23. The Chief Compliance Officer of the Filer is responsible for establishing and maintaining policies and procedures in connection with the use of derivatives, oversight of all derivative strategies used by the Funds, and the monitoring and assessing compliance with all applicable legislation. The Chief Compliance Officer is required to report to the Ultimate Designated Person of the Filer on any instances of non-compliance and reports to the board of directors of the Filer on his or her compliance assessments. The board of directors of the Canoe Financial Corp., the general partner of Canoe reviews and approves the Filer's policies and procedures in connection with the use of derivatives and has the ultimate responsibility of ensuring that proper policies and procedures relating to the use of derivatives are in place.
24. As part of its ongoing review of fund activity, compliance personnel employed by the portfolio manager and the sub-advisor and the Filer review the use of derivatives as part of their ongoing review of fund activity.
25. Limits and controls on the use of derivatives are part of the Filer's fund compliance regime and include reviews to ensure that the derivative positions of the Funds are within applicable policies.
26. Without the Exemption Sought, the Funds will not have the flexibility to enhance yield and to manage more effectively their exposure under specified derivatives.
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 Exemption Sought is granted provided that:
(a) the Fixed Income Securities have a remaining term to maturity of 365 days or less and have an "approved credit rating" as defined in NI 81-102;
(b) the Floating Rate Securities meet the following requirements:
(i) the floating interest rates of the Floating Rate Securities reset no later than every 185 days;
(ii) the Floating Rate Securities are floating rate evidences of indebtedness with the principal amounts of the obligations that will continue to have a market value of approximately par at the time of each change in the rate to be paid to the holders of the evidences of indebtedness;
(iii) if the Floating Rate Securities are issued by a person or company other than a government or "permitted supernational agency" as defined in NI 81-102, the Floating Rate Securities must have an "approved credit rating" as defined in NI 81-102;
(iv) if the Floating Rate Securities are issued by a government or permitted supranational agency, the Floating Rate Securities have their principal and interest fully and unconditionally guaranteed by:
(1) the government of Canada or the government of a jurisdiction in Canada; or
(2) the government of the United States of America, the government of one of the states of the United States of America, the government of another sovereign state or a "permitted supernational agency" as defined in NI 81-102 if, in each case, the Floating Rate Security has an approved credit rating as defined in NI 81-102; and
(v) the Floating Rate Securities meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
(c) a Fund shall not open or maintain 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 unless the 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 amount, if any, by which the strike 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 subparagraphs (i) and (ii) that is sufficient, without recourse to other assets of the Fund, to enable the Fund to acquire the underlying interest of the future or forward contract;
(d) a Fund shall not enter into or maintain a swap position unless for periods when the Fund would be entitled to receive fixed payments under the swap, the 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 mark-to-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 Fund under the swap less the obligations of the Fund under such offsetting swap; or
(iii) a combination of the positions referred to in subparagraphs (i) and (ii) that is sufficient, without recourse to other assets of the Fund, to enable the Fund to satisfy its obligations under the swap;
(e) a Fund shall 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 section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-102, if immediately after the purchase or writing of such option, more than 10% of the net assets of the 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 Fund for purposes other than hedging, or (2) options used to cover any positions under section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-102; and
(f) each Fund shall:
(i) disclose the nature and terms of this relief in its annual information form with a cross reference thereto in the Fund's prospectus; and
(ii) shall include a summary of the nature and terms of this relief in the Fund's prospectus under the Investment Strategies section or in the introduction to Part B of the prospectus with a cross reference thereto under the Investment Strategies section for the Fund.
APPENDIX "A"
LIST OF PRELIM FUNDS