Proposed changes to NI 81-102 relevant for derivatives and securities lending
P. Jason Kroft and Sarah Horan
On June 25, 2010, the Canadian Securities Administrators (CSA) published for comment proposed amendments to National Instrument 81-102 Mutual Funds (NI 81-102) and related instruments, which set out the regulatory framework for mutual funds under Canadian securities legislation. Certain of the proposed amendments are relevant for derivatives and securities lending, the salient aspects of which are described below.
The proposed amendments seek to codify frequently granted exemptive relief from the requirements under NI 81-102, create additional operational requirements for money market funds and generally update the instrument to reflect changes in the Canadian marketplace and the evolution of regulatory approaches to mutual funds in other major markets. Included among the amendments are several changes relating to the use of short-selling and specified derivatives by mutual funds.
The CSA are proposing an amendment to Part 2 of NI 81-102, which would allow mutual funds to engage in limited short-selling of securities subject to certain conditions. Previously, mutual funds wishing to engage in short-selling were forced to operate under ad hoc relief granted by securities regulatory authorities.
Under the proposed amendments, a mutual fund will be permitted to sell securities short subject to it having borrowed the security being sold short; there being a cap on short-selling of 20% of its net asset value (NAV); there being a limit on its total exposure to any one issuer through short-sales of 5% of its NAV and it holding a cash cover in an amount that is at least 150% of the aggregate market value of all its short positions on a daily mark to market basis. The proceeds of any such short sale may not be used to enter into long positions in securities other than the cash cover, thus eliminating the possibility of long/short strategies.
The proposed codification of exemptive relief eliminates unnecessary regulatory burdens and reduces costs and delays associated with the application for such relief. However, the ability of a mutual fund to engage in short-selling may be hampered by the requirement that it borrow the security being sold short. The proposed amendments do not include any changes to Section 2.12, which only allows mutual funds to enter into securities lending arrangements as lender. Allowing mutual funds to borrow securities through securities lending arrangements could potentially reduce the cost of borrowing securities and provide a mutual fund with greater access to borrowed securities.
The CSA are also proposing the removal of the term limit on specified derivatives. Mutual funds will no longer be limited in the term to maturity of the fixed income securities in which they can invest. As a result, mutual funds will be able to enter into derivatives that match the term to maturity of their fixed income holdings and they will be able to offset their positions at any time by entering into an opposing transaction. It has been our experience that one area of concern for financial intermediaries and counterparties to mutual funds has been how to manage the risk of early termination or wind-up of the derivative positions given the current term maturity restrictions.
Finally, the CSA are proposing an amendment to the definition of “cash cover” to include: (i) evidence of indebtedness with a remaining term to maturity of 365 days or less and an approved credit rating; (ii) certain floating rates reset no less frequently than every 165 days and the principal amounts of which continue to have a market value of approximately par on each rate reset; and (iii) securities of money market mutual funds. These changes to the definition of “cash cover” will provide mutual funds with greater flexibility in selecting securities for use as cash cover.
We will be watching as the proposals are further developed and introduced and will provide further updates on developments of interest relating to these proposed amendments.
