NIN 2000/04 - Publication for Comment of Proposed Amendments to National Instrument and Forms Governing Mutual Funds and Consequential Amendments to the Securities Rules and the Securities Regulation Relating to Securities Lending and Other Matters [NIN - Rescinded]

The Commission, together with other members of the Canadian Securities Administrators (“CSA”) is today publishing for comment proposed amendments to Form 81-101F1 Contents of Simplified Prospectus, Form 81-101F2 Contents of Annual Information Form (collectively, the “Forms”), National Instrument 81-102 Mutual Funds (“NI 81-102”) and Companion Policy 81-102CP (“81-102CP”). The proposed amendments are primarily focussed on permitting mutual funds to enter into securities lending, repurchase and reverse repurchase transactions on a basis that the CSA believe would be appropriate to ensure both investor protection and permit mutual funds to realize the potential benefits of these transactions for their securityholders.

The proposed amendments to the Forms, NI 81-102 and 81-102CP are initiatives of the CSA and are expected to be adopted as a rule in each of British Columbia, Alberta, Manitoba, Ontario and Nova Scotia, as a Commission regulation in Saskatchewan and as a policy in all other jurisdictions represented by the CSA.

Substance and Purpose of the Proposed Amendments to NI 81-102, 81-102CP and the Forms

The proposed amendments to NI 81-102 will amend the investment restrictions otherwise contained in that Instrument to permit mutual funds to enter into securities lending, repurchase and reverse repurchase transactions in accordance with specified conditions. The proposed amendments also implement a number of miscellaneous amendments to NI 81-102 not related to securities lending.

The proposed amendments to 81-102CP add to the discussion of the CSA’s views on certain issues relating to securities lending, repurchase and reverse repurchase transactions, and provide interpretation of the provisions to be added to NI 81-102. Included with these amendments are the CSA’s views on the appropriate application of Canadian generally accepted accounting principles (“GAAP”) in the context of mutual funds engaging in these types of transactions.

The proposed amendments to the Forms add to the disclosure requirements for a simplified prospectus and an annual information form of a mutual fund that intends to lend its securities or use repurchase and reverse repurchase transactions.

Background

The CSA recently completed two major initiatives that substantially update and reform many aspects of mutual fund regulation in Canada which come into effect on February 1, 2000. The two initiatives are:

(a) National Instrument 81-101 (“NI 81-101”), the Forms, and Companion Policy 81-101CP (“81-101CP”), which replace National Policy No. 36¹

¹See Nin#2000/1.

; and

(b) NI 81-102 and 81-102CP, which replace National Policy 34 and National Policy Statement No. 39²

²See Nin#2000/2.

In finalizing NI 81-102, the CSA were aware that there remain a number of important regulatory issues relating to mutual funds that require the attention of the CSA and possible changes to the regulatory requirements. These remaining issues include:

· Securities lending by mutual funds and the use of repurchase agreements by mutual funds;

· A standardized regime for the structure of so-called funds of funds;

· Timing of transfers among financial institutions and among mutual funds;

· Principal trading in securities between mutual funds and entities related to the manager of the mutual fund;

· Acquisition of securities by mutual funds from underwriters related to the mutual fund manager; and

· Inter-fund trading of securities.

Rules relating to securities lending, repurchase and reverse repurchase transactions are proposed to be effected through these proposed amendments.

The CSA received comments during the first comment period for NI 81-102 urging them to permit mutual funds to lend their securities and use repurchase agreements and reverse repurchase agreements. The Investment Dealers Association of Canada (the “IDA”) and The Investment Funds Institute of Canada (“IFIC”) were strong advocates. Following receipt of these comments, staff of certain members of the CSA worked with an IDA-organized group to determine the extent to which it would be appropriate to permit mutual funds to engage in these investment practices. Staff also sought assistance from securities lending agents, and mutual fund organizations, to understand the risks inherent in these practices, and the extent to which proper parameters would alleviate these risks.

In addition, the CSA reviewed a white paper on securities lending in the United States prepared by the Investment Company Institute³

³Securities Operations Subcommittee and Custodians Advisory Group, Securities Lending for Mutual Funds, (white paper) by Diane M. Butler et al., Washington D.C., U.S.A.: Investment Company Institute, October 30, 1998.

and the survey on securities lending practices world-wide prepared by the International Organization of Securities Commissions⁴

⁴The International Organization of Securities Commissions (IOSCO), Securities Lending Transactions: Market Development and Implications, Joint Report by the Technical Committee and the Committee on Payment and Settlement Systems, Montreal, Canada: IOSCO, July 1999.

Both papers provided the CSA with valuable guidance and assistance in understanding the issues. The CSA also received the guidelines for securities lending by pension plans and life insurance companies (the “Guidelines”) developed by the Office of the Superintendent of Financial Institutions (“OSFI”)⁵.

⁵OSFI Guidelines Pensions B-4 Securities Lending - Pension Plans (February 1992) and OSFI Guidelines Life Insurance Companies/Fraternal Benefit Societies B-4 Securities Lending (February 1997).

In addition, during the final comment period for NI 81-102, the CSA received a number of useful comments that would have required additional changes to that instrument. The CSA decided to address some of these comments by amending NI 81-102 after it came into force, so as not to delay the implementation of NI 81-102 through a further comment period. Also included in these proposed amendments are proposed revisions to NI 81-102, which the CSA determined were necessary as a result of comments received by the CSA after advance notice was published on November 12, 1999⁶

⁶NIN #99/39

The CSA are continuing to work on the other issues listed previously, and will propose their courses of action with respect to those issues in due course.

Summary of Proposed Amendments to NI 81-102

· Amends the definition of “cash cover” to add two new types of portfolio assets that can be used as cash cover to include securities purchased by a mutual fund on a reverse repurchase transaction to the extent of the cash paid for those securities by the mutual fund, and corporate commercial paper of a specified type.

· Adds a definition of “qualified security”. The proposed definition is identical to that of “cash equivalents” in NI 81-102, but eliminates the short term maturity. This definition will limit the type of collateral a mutual fund may receive in a securities lending or repurchase transaction, and the type of investment a mutual fund may make on a reverse repurchase transaction.

· Adds provisions that will set out conditions to be satisfied by a mutual fund for it to enter a securities lending transaction as lender, to enter into repurchase transactions, and to enter into reverse repurchase transactions.

· Adds provisions that will set out requirements relating to the use of an agent by the mutual fund to administer its securities lending, repurchase and reverse repurchase transaction.

· Imposes reporting and review requirements on both the agent and the mutual fund for securities lending, repurchase and reverse repurchase transactions.

· Imposes requirements prohibiting entering into securities lending, repurchase or reverse repurchase transactions without appropriate prospectus disclosure, or a notice of intent to securityholders.

· Imposes requirements prohibiting a mutual fund from entering into securities lending, repurchase and reverse repurchase transactions with related parties.

· Amends existing provisions to clarify that certain standard of care provisions do not apply to actions of a custodian in administering a securities lending, repurchase or reverse repurchase transactions because the proposed amendments set out a separate standard of care in these situations.

· Places restrictions on the amount of assets of a mutual fund that may be deposited with any one counterparty.

· Clarifies how performance data may be presented in sales communications for mutual funds with different classes or series of securities.

· Imposes new rules dealing with the calculation of the management expense ratio for a mutual fund that has exposure to one or more other mutual funds through the use of specified derivatives.

· Clarifies the application of the provisions relating to the calculation of management expense ratios for financial periods ended before NI 81-102 comes into force.

· Clarifies the application of provisions relating to the provision of reports to securityholders to clarify that NI 81-102 does not apply to reports to securityholders that include only financial statements for financial periods ending before NI 81-102 comes into force.

Summary of Proposed Amendments to 81-102CP

· Adds a number of provisions setting out interpretative matters in relation to securities lending, repurchase and reverse repurchase transactions. These include the types of matters that should be contained in securities lending agreements, the nature of cash cover and monitoring of corporate developments of loaned securities.

· Includes a discussion about how Canadian GAAP applies to mutual funds engaged in securities lending, repurchase and reverse repurchase transactions, and general financial disclosure matters.

Summary of Proposed Amendments to the Forms

· Amends Form 81-101F1 (which contains the disclosure requirements for a simplified prospectus of a mutual fund) by adding requirements regarding disclosure of the mutual fund’s intent to enter into securities lending, repurchase and reverse repurchase agreements, and risk factor disclosure for these types of transactions.

· Amends Form 81-101F2 to expand disclosure requirements for an annual information form to require a mutual fund to disclose its policies and practices to manage the risks associated with securities lending, repurchase and reverse repurchase transactions and to disclose the organization and administration of a mutual fund’s transactions.

Specific Questions of the CSA

In addition to welcoming submissions on any provision proposed in the amendments relating to securities lending, repurchase and reverse repurchase transactions, the CSA seek comment on the specific matters referred to below.

The CSA note that the regulation of securities lending in the United States contains elaborate provisions where the collateral for a securities loan is irrevocable letters of credit issued by financial institutions. The U.S. regulations also permit other forms of collateral. The CSA have not provided for irrevocable letters of credit to be used as collateral and propose that the only appropriate collateral be those instruments defined as “qualified securities”. The CSA invite comment on whether the definition of “qualified securities” should be expanded to include irrevocable letters of credit or other specified financial instruments as eligible collateral and, if so, what parameters should be developed. The CSA would appreciate comments as to why any such additional financial instruments would be appropriate collateral for a securities loan.

A condition placed on securities loans, repurchase and reverse repurchase transactions in proposed sections 2.12, 2.13 and 2.14 is that the transaction must be a “securities lending arrangement” under section 260 of the Income Tax Act (Canada) (the “ITA”). The CSA invite comment on whether this condition is too restrictive and whether a reference to the ITA is necessary. If applicable, the CSA would appreciate comment on why this condition is too restrictive.

The proposed amendments require that a securities loan be an overnight transaction. A mutual fund must be able to recall loaned securities within normal and customary settlement periods. Similarly, repurchase and reverse repurchase transactions must be no more than five business days, before any extension or renewal that requires the consent of both the mutual fund and the counterparty. The CSA invite comment on the appropriateness of these restrictions on the terms of the transactions - in particular specific information regarding the practicality of these restrictions with reference to increases in risks to the mutual fund associated with longer terms.

Cash received (either as collateral or as proceeds of sale) may only be invested in qualified securities or in a reverse repurchase transaction having a term to maturity no longer than the initial transaction. The CSA invite comment on whether this reinvestment restriction is appropriate and practical with regard to these transactions. The CSA invite these comments to address the appropriateness and level of “mismatch risk” that a mutual fund should be allowed to achieve in investing cash that it receives under its securities lending and repurchase transactions.

Proposed sections 2.12 and 2.13 provide for an aggregate volume limit on the market value of securities of the mutual fund that can be out on loan or sold pursuant to repurchase transactions. This limit is proposed to be 33 1/3 percent of the total assets of the mutual fund, including collateral received under the transactions. The CSA invite comment on whether this aggregate limit should be a separate limit for securities loans and a separate limit for repurchase transactions and if so, why, with reference to any increased risks to the mutual fund. No limits are proposed for transactions with any one counterparty. The CSA invite comment on whether limits are necessary or whether counterparty risk is adequately dealt with through the over-collateralization requirements, the limits on the types of collateral to be received and the requirement to use an agent.

As noted above, the CSA are aware that the OSFI Guidelines require that the lender take an adequate amount of collateral which is at least 105 percent (in Canada) of the market value of the securities lent. The CSA chose to include the lower level of over-collateralization of 102 percent, as that level reflects current practice in the United States, and increasingly, also in Canada. The proposed amendments to 81-102CP underscore that the 102 percent requirement must be supplemented if best practices in the local market require greater levels of collateral.

The CSA invite comment on whether the proposed collateral requirement is too low, and if so, comment on what additional risks are being taken on by a mutual fund with this level of over-collateralization. Conversely, if a commenter is of the view that the collateral requirements are not too low, the CSA would appreciate submissions on those views.

The CSA invite comment on whether any of the other restrictions proposed will unduly reduce the potential for revenues for mutual funds. Commenters who propose lesser restrictions should consider whether these lesser restrictions will increase the risks to mutual funds and comment on how these risks can be properly managed and balanced in favour of investor protection.

Alternatives Considered

The CSA considered maintaining the prohibition on securities lending, repurchase and reverse repurchase transactions. The CSA also considered additional conditions to allow mutual funds to engage in these practices, such as restrictions on the geographic location of counterparties and limits on the amounts that a mutual fund could lend to any one counterparty. The proposed amendments represent the CSA’s views on the appropriate level for these investment practices to be adopted by mutual funds, without unduly subjecting those mutual funds to additional, unjustifiable risks.

Anticipated Costs and Benefits

The proposed amendments to NI 81-102, the Forms and 81-102CP permit mutual funds that wish additional investment flexibility to engage in additional investment practices. As such, the proposed amendments impose no increased regulatory burdens on mutual funds. Securities lending, repurchase and reverse repurchase transactions are expected to generate additional revenues for mutual fund for the benefit of investors.

The proposed amendments do not give mutual funds total freedom to lend securities or enter repurchase or reverse repurchase transactions. A major cornerstone of the proposed regime is that mutual funds must use an agent to carry out these transactions in order that operational risks to mutual funds inherent with these practices be minimized. Revenues to a mutual fund from these practices will be reduced to the extent of the fees charged by such agents.

Consequential Amendments

Consequential amendments to the Securities Rules are proposed to replace the requirements for financial statements, in section 3(13), with requirements that accord with the requirements set out in NI 81-102. Similarly, amendments are proposed to the Securities Regulation, to amend the provisions applicable to money market mutual funds, to accord with the definition set out in NI 81-102.

Comments

Interested parties are invited to make written submissions with respect to the proposed amendments. Submissions received by April 30, 2000 will be considered.

Submissions should be sent to all of the Canadian securities regulatory authorities listed below in care of the Ontario Securities Commission, in duplicate, as indicated below:

British Columbia Securities Commission
Alberta Securities Commission
Saskatchewan Securities Commission
The Manitoba Securities Commission
Office of the Administrator, New Brunswick
Registrar of Securities, Prince Edward Island
Nova Scotia Securities Commission
Securities Commission of Newfoundland
Registrar of Securities, Northwest Territories
Registrar of Securities, Nunavut
Registrar of Securities, Yukon Territory

c/o John Stevenson, Secretary
Ontario Securities Commission
20 Queen Street West
Suite 800, Box 55
Toronto, Ontario M5H 3S8
jstevenson@osc.gov.on.ca

Submissions should also be addressed to the Commission des valeurs mobilières du Québec as follows:

Claude St. Pierre, Secretary
Commission des valeurs mobilières du Québec
800 Victoria Square
Stock Exchange Tower
P.O. Box 246, 22nd Floor
Montréal Québec H4Z 1G3
claude.stpierre@cvmq.ca

A diskette containing the submissions (in DOS or Windows format, preferably WordPerfect) should also be submitted. As securities legislation in certain provinces required that a summary of written comments received during the comment period be published, confidentiality of submissions cannot be maintained.

Comments may also be send via e-mail to the above noted e-mail addresses of the respective Secretaries of the Ontario Commission and of the Commission des valeurs mobilières du Québec, and also to any of the individuals noted below at their respective e-mail addresses.

Questions may be referred to any of:

Noreen Bent
Senior Legal Counsel
British Columbia Securities Commission
(604) 899-6741 or
(800) 373-6393 (in B.C.)
nbent@bcsc.bc.ca

Wayne Alford
Legal Counsel
Alberta Securities Commission
(403) 297-2092
wayne.alford@seccom.ab.ca

Dean Murrison
Deputy Director, Legal
Saskatchwan Securities Commission
(306) 787-5879
dean.murrison.ssc@govmail.gov.sk.ca

Bob Bouchard
Director, Capital Markets and Chief Administrative Officer
The Manitoba Securities Commission
(204) 945-2555
bbouchard@cca.gov.mb.ca

Rebecca Cowdery
Manager, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8129
rcowdery@osc.gov.on.ca

Anne Ramsay
Accountant, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8243
aramsay@osc.gov.on.ca

Darren McKall
Legal Counsel, Investment Funds
Capital Markets
Ontario Securities Commission
(416) 593-8118
dmckall@osc.gov.on.ca

Pierre Martin
Legal Counsel, Service de la réglementation
Commission des valeurs mobilières du Québec
(410) 940-2199, ext. 4557
pierre.martin@cvmq.ca

Renee Piette
Conseillere a la réglementation
Commission des valeurs mobilières du Québec
(514) 940-2199, ext. 4558
renee.piette@cvmq.ca

DATED at Vancouver, British Columbia, on January 26, 2000.

Douglas M. Hyndman
Chair

Ref: NI 81-101
81-101CP
Form 81-101F1
Form 81-101F2
NI 81-102
81-102CP
NIN#99/39
NIN#2000/1
NIN#2000/2
NP 36
NPS 39
Section 3(13), Securities Rules

This NIN refers to other documents. These documents can be found at the B.C. Securities Commission public website at www.bcsc.bc.ca in the Policy Documents database.