Lysander Funds Limited and Canso Credit Income Fund
Headnote
National Policy 11-203 -- Process for Exemptive Relief applications in Multiple Jurisdictions -- relief granted from short selling restrictions in National Instrument 81-102 Investment Funds to permit a non-redeemable investment fund to short sell "government securities" up to 300% of net asset value in connection with the fund's investment strategies -- relief subject to conditions -- relief also granted to a non-redeemable investment fund to permit the fund to deposit with a prime broker, excluding the value of the proceeds from short sales held as collateral, additional collateral subject to 25% of the fund's net asset value -- relief subject to conditions.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6.1(1)(c)(v), 2.6.2, 6.1(1), and 19.1.
June 10, 2021
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO (the Jurisdiction) AND IN THE MATTER OF THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS AND IN THE MATTER OF LYSANDER FUNDS LIMITED (the Filer) AND CANSO CREDIT INCOME FUND (the Fund)
DECISION
Background
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Fund for a decision under the securities legislation of the Jurisdiction (the Legislation) exempting:
1. the Fund from the following provisions (the Short Selling Limits) of National Instrument 81-102 Investment Funds (NI 81-102) in order to permit the Fund to short sell "government securities" (as defined in NI 81-102) up to a maximum of 300% of the Fund's net asset value (NAV):
(a) subparagraph 2.6.1(1)(c)(v) of NI 81-102, which restricts the Fund from selling a security short if, at the time, the aggregate market value of the securities sold short by the Fund exceeds 50% of the Fund's NAV; and
(b) section 2.6.2 of NI 81-102, which states that the Fund may not borrow cash or sell securities short if, immediately after entering into a cash borrowing or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the Fund would exceed 50% of the Fund's NAV
(collectively, the Short Selling Relief); and
2. the Fund from the requirement set out in subsection 6.1(1) of NI 81-102 that provides that, except as provided in section 6.8, 6.8.1 and 6.9, all portfolio assets of an investment fund must be held under the custodianship of one custodian that satisfies the requirements of section 6.2 (the Custodial Restriction) in order to permit the Fund to deposit portfolio assets with a borrowing agent that is not the Fund's custodian or sub-custodian as security in connection with a short sale of securities, provided that the aggregate market value of the portfolio assets held by the borrowing agent after such deposit, excluding the aggregate market value of the proceeds from outstanding short sales of securities held by the borrowing agent, does not exceed 25% of the NAV of the Fund at the time of deposit (the Custodial Relief)
(together with the Short Selling Relief, the Exemption Sought).
Under the process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada other than the Jurisdiction (together with the Jurisdiction, the Canadian Jurisdictions).
Interpretation
In this decision, unless expressly defined herein, terms in this decision have the respective meanings given to them in MI 11-102, National Instrument 15-101 Definitions and NI 81-102.
Representations
The decision is based on the following facts represented by the Filer:
The Filer
1. The Filer is a corporation incorporated under the Business Corporations Act (Ontario) with its head office located in Toronto, Ontario.
2. The Filer is registered as an investment fund manager in Ontario, Quebec, and Newfoundland and Labrador, as a portfolio manager in Ontario and as an exempt market dealer in Ontario.
3. The Filer is the investment fund manager of the Fund.
4. Neither the Filer nor the Fund is in default of securities legislation in any of the Canadian Jurisdictions.
The Fund
5. The Fund is a non-redeemable investment fund (NRIF) as defined in NI 81-102, established under the laws of Ontario by way of a declaration of trust dated as of June 28, 2010, as amended and restated as of June 24, 2015 and as the same may be further amended and/or restated from time to time. The Fund currently has Class A units and Class F units issued and outstanding. Class A units of the fund trade on the Toronto Stock Exchange under the symbol PBY.UN. Class F units of the Fund are designed for fee-based and/or institutional accounts and are not listed on a stock exchange, but are convertible into Class A units on a monthly basis. Class A and Class F units of the Fund were first issued in connection with the initial public offering of the Fund on July 16, 2010.
6. The investment objectives of the Fund are to maximize total returns for unitholders while reducing risk, and to provide unitholders with monthly cash distributions by taking long and short positions primarily in corporate bonds and other income securities.
7. The Fund's portfolio holdings are not restricted by credit ratings. In addition, the portfolio manager engages in short selling of securities primarily to hedge credit and interest rate risk. This allows the Fund's portfolio to be positioned more defensively in both rising interest rate environments and credit downturns.
8. The Fund is not considered to be a mutual fund under the securities legislation of the Canadian Jurisdictions. Consequently, the Fund is not subject to the various policies and regulations that apply to mutual funds under such legislation. The Fund is governed by certain other requirements and restrictions contained in applicable securities laws, such as NI 81-102, subject to any relief granted therefrom by the Canadian securities regulatory authorities.
9. The Fund intends to file a preliminary base shelf prospectus in accordance with National Instrument 44-102 Shelf Distributions in order to provide the Fund with flexibility to offer additional units (including additional classes of units) of the Fund by way of a supplement to the base shelf prospectus. Although the Short Selling Limits do not currently apply to the Fund due to section 1.2(5) of NI 81-102, they will apply once a receipt for the base shelf prospectus is issued.
The Short Selling Relief
10. An important investment strategy expected to be used by the Fund will be to enter into long positions in corporate bonds while hedging the interest rate risk of those bonds by taking short positions in government bonds (the Short Hedging Strategy). The Short Hedging Strategy is effective because there is a high degree of correlation between the movement of government and corporate fixed income securities caused by changes in interest rates, creating a hedge against losses in the value of the long corporate position. This relationship is a fundamental part of the fixed-income market such that dealers quote the price of corporate bond based on the incremental yield of the corporate bonds over an equivalent term government bond.
11. The Short Selling Limits would restrict the the Fund to short selling government securities to no more than 50% of the Fund's NAV.
12. The only securities proposed to be sold short by the Fund in excess of 50% of the Fund's NAV will be "government securities" as such term is defined in NI 81-102. The Fund will otherwise comply with the provisions governing short selling by a NRIF under sections 2.6.1 and 2.6.2 of NI 81-102.
13. NI 81-102 otherwise permits the Fund to obtain the additional leveraged short exposure through the use of specified derivatives, up to an aggregate exposure of 300% of the Fund's NAV.
14. The Filer is of the view that it would be in the Fund's best interest to permit the Fund to physically short sell government securities up to 300% of the Fund's NAV, instead of being limited to achieving the same degree of leverage through either specified derivatives alone, or a combination of physical short selling and specified derivatives, for the following reasons:
(a) While derivatives can be used to create similar investment exposure as the Short Hedging Strategy up to 300% of the Fund's NAV, the use of derivatives is less effective, is more complex, and is riskier than the Short Hedging Strategy. Derivatives typically provide credit exposure that is less targeted than the Short Hedging Strategy with a longer duration that increases risk, often without commensurately higher returns. In addition, implementing derivatives strategies necessitates incremental transactional steps. These steps increase both operational risk and counterparty risk, as well as cost.
(b) The risk of covering short government securities positions in a rising market is largely mitigated by several factors: (i) the strong correlation between the government security sold short and the corporate fixed income security held long by the Fund which provides a hedge against short cover risk; (ii) government securities are highly liquid and more than one issuance of government securities can be used to hedge interest rate risk; (iii) government securities have markedly lower price volatility than equity securities; (iv) unlike equity securities, government securities have an effective upper value limit; and (v) financial institutions that facilitate short selling are regulated and implement effective risk controls on short sellers.
15. The Fund's aggregate exposure to short selling, cash borrowing and specified derivatives transactions will not exceed 300% of the Fund's NAV, in compliance with subsection 2.9.1 of NI 81-102 (the Aggregate Exposure Limit).
16. The Fund will implement the following controls when conducting a short sale:
(a) the Fund will assume the obligation to return to the borrowing agent (as defined in NI 81-102) the securities borrowed to effect the short sale;
(b) the Fund will receive cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer will cause the portfolio manager of the Fund to monitor the short positions of the Fund at least as frequently as daily and the Filer, as investment fund manager, will monitor the short positions of the Fund at least as frequently as monthly;
(d) the security interest provided by the Fund over any of its assets that is required to enable the Fund to effect a short sale transaction is made in accordance with section 6.8.1 of NI 81-102 and will otherwise be made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transaction;
(e) the Fund will maintain appropriate internal controls regarding short sales, including written policies and procedures for the conduct of short sales, risk management controls and proper books and records; and
(f) the Filer will cause the portfolio manager of the Fund, on behalf of the Fund, to keep proper books and records of short sales and all of the Fund's assets deposited with borrowing agents (as defined in NI 81-102) as security and the Filer, on behalf of the Fund, will have access to such books and records.
17. The Fund's prospectus will contain adequate disclosure of the Fund's short selling activities, including material terms of the Short Selling Limits.
The Custodial Relief
18. In connection with, among other things, the short sale of securities that the Fund will or may engage in, the Fund is permitted to grant a security interest in favour of, and deposit pledged portfolio assets with, the entity that acts as, among other things, a borrowing agent (the Prime Broker) to it. If the Fund engages as its Prime Broker an entity that is not its custodian or sub-custodian, then it may, under section 6.8.1 of NI 81-102, only deliver to its Prime Broker portfolio assets having a market value, in the aggregate, of not more than 25% of the NAV of the Fund at the time of deposit.
19. A Prime Broker may not wish to act as borrowing agent for the Fund that wants to sell short securities having an aggregate market value of up to 300% if the Prime Broker is only permitted to hold, as security for such transactions, portfolio assets, including the proceeds from the short sale, having an aggregate market value that is not in excess of 25% of the NAV of the Fund.
20. Effective as of January 3, 2019, NI 81-102 was amended to permit alternative mutual funds and NRIFs to have aggregate exposure to cash borrowing, short selling and specified derivatives up to 300% of the fund's NAV. The ability of these funds to borrow cash and to sell short securities more extensively than other investment funds governed by NI 81-102 has led to the increased involvement of Prime Brokers in the operations of alternative mutual funds and NRIFs. While the prime brokerage model works well in the exempt investment fund space, the prime brokerage community and investment fund managers are experiencing greater difficulties in applying that model to alternative mutual funds and NRIFs under NI 81-102.
21. The prime brokerage operational and pricing models in the context of short selling are premised on the ability of the Prime Broker to retain, as collateral for the obligations of the Fund, the proceeds from the short sales, whether such proceeds are cash or are used by the Fund to purchase other portfolio assets. These models are also based on the ability of the Prime Broker to hold additional assets of the Fund as collateral for those obligations.
22. Given the collateral requirements that Prime Brokers impose on their customers that engage in the short sale of securities, if the 25% of NAV limitation set out in section 6.8.1 of NI 81-102 applies, then the Fund will need to retain two, or more, Prime Brokers in order to sell short securities to the extent permitted under section 2.6.1 of NI 81-102. This would result in inefficiencies for the Fund and would increase its costs of operations.
Decision
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator under the Legislation is that the Exemption Sought is granted provided that:
1. In the case of the Short Selling Relief:
(a) the only securities which the Fund will sell short in an amount that exceeds 50% of the Fund's NAV will be securities that meet the definition of a "government security" as such term is defined in NI 81-102;
(b) each short sale by the Fund will otherwise comply with all of the short sale requirements applicable to NRIFs in sections 2.6.1 and 2.6.2 of NI 81-102;
(c) the Fund's aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed the Aggregate Exposure Limit;
(d) each short sale will be made consistent with the Fund's investment objectives and investment strategies; and
(e) the Fund's prospectus will disclose that the Fund is able to short sell "government securities" (as defined in NI 81-102) in an amount up to 300% of the Fund's NAV, including the material terms of this decision.
2. In the case of the Custodial Relief, the Fund otherwise complies with subsections 6.8.1(2) and (3) of NI 81-102.