Mutual Reliance Review System for Exemptive Relief Applications -- s. 19.1 of National Instrument 81-102 Mutual Funds -- exemption from section 2.7 (1)(a) of NI 81-102 to permit interest rate and credit derivative swaps with a remaining term to maturity of greater than 3 years; exemption from section 2.8(1) of NI 81-102 to the extent that cash cover is required in respect of specified derivatives to permit the Funds to cover specified derivative positions with: any bonds, debentures, notes or other evidences of indebtedness that are liquid; and exemption from sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the Funds when they open or maintain a long position in a standardized future or forward contract or when they enter into or maintain an interest rate swap position and during the periods when the Funds are entitled to receive payments under the swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 2.8(1)(d), 2.8(1)(f)(i), 19.1.
August 8, 2007
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
BRITISH COLUMBIA, ALBERTA, SASKATCHEWAN,
MANITOBA, ONTARIO, QUEBEC, NEW BRUNSWICK,
NOVA SCOTIA, PRINCE EDWARD ISLAND,
NEWFOUNDLAND AND LABRADOR, NORTHWEST
TERRITORIES, NUNAVUT and YUKON
IN THE MATTER OF
THE MUTUAL RELIANCE REVIEW SYSTEM
FOR EXEMPTIVE RELIEF APPLICATIONS
IN THE MATTER OF
PHILLIPS, HAGER & NORTH INVESTMENT
MANAGEMENT LTD. (THE FILER)
THE FUNDS LISTED IN APPENDIX A
MRRS DECISION DOCUMENT
The local securities regulatory authority or regulator (the Decision Maker) in each of the Jurisdictions has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation) exempting the funds set out in Appendix A, together with all future funds managed by the Filer that invest in, or gain exposure to, fixed income securities or a combination of fixed income securities and equity securities (collectively, the Funds), pursuant to Section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102) from:
(a) the requirement in section 2.7(1)(a) of NI 81-102, to the extent that it requires a swap or forward to have a remaining term to maturity of three years (or five years in certain circumstances), to permit the Funds to enter into an interest rate swap or credit default swap or, if the transaction is for hedging purposes, currency forwards, in all cases with a remaining term to maturity of greater than three years;
(b) the requirement in section 2.8(1) of NI 81-102, to the extent that cash cover is required in respect of specified derivatives, to permit the Fund to cover specified derivative positions with (i) any bonds, debentures, notes or other evidences of indebtedness that are liquid (Fixed Income Securities), or (ii) floating rate evidences of indebtedness; and
(c) the requirement in 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.
(paragraphs (a), (b) and (c) collectively will be referred to as the Requested Relief)
Under the Mutual Reliance Review System for Exemptive Relief Applications:
(a) British Columbia is the principal regulator for this application, and
(b) this MRRS decision document evidences the decision of each Decision Maker.
Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are defined in this decision.
This decision is based on the following facts represented by the Filer:
The Filer and the Funds
1. The Filer is a company organized under the laws of British Columbia and having its head office in British Columbia.
2. The Filer is or will be the manager of the Funds and is currently the portfolio adviser of the Funds. The portfolio adviser of the Funds may be an affiliate of the Filer or an unrelated third party.
3. Each of the Funds is or will be a mutual fund established as a trust under the laws of British Columbia, the securities of which are or will be offered for sale pursuant to a prospectus filed in the Jurisdictions. The Funds are or will be reporting issuers in each of the Jurisdictions.
4. The investment objectives and strategies of the Funds are disclosed in the prospectus for each Fund. The common element of their investment strategies is investing in, or gaining exposure to fixed income securities, such as bonds and debentures issued by governments and corporations, or a combination of fixed income securities and equity securities.
5. The Funds may use derivative instruments in a manner consistent with their investment objectives as permitted under Canadian securities laws. The Funds may use derivative instruments for hedging purposes, including protection against losses from changes in interest rates and market indices, protection against fluctuations in the value of foreign currency relative to the Canadian dollar or to substitute a risk to one currency for a risk to another currency. The Funds may use derivative instruments for non-hedging purposes, including as a substitute for direct investment.
Interest Rate Swaps, Credit Default Swaps and Currency Forwards for Hedging Purposes
6. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into certain over-the-counter (OTC) derivatives transactions, with terms to maturity of greater than three years, or greater than five years if the contract provides the fund with a right to eliminate its exposure within three years. The Filer seeks the ability for it or others, on behalf of the Funds, to enter into interest rate swaps and credit default swaps or, if the transaction is for hedging purposes, currency forwards without a restriction as to term of the swap or forward.
7. Fixed income investments have risks that include, but are not limited to, interest rate risk, credit risk and currency risk. These risks can be controlled or mitigated through the use of OTC derivatives. Interest rate risk may be managed by interest rate swaps, credit risk may be managed by credit default swaps and currency risk may be managed through currency forwards. OTC derivatives can also provide exposure to specific types of fixed income investments in a more efficient and cost-effective manner than investing in the underlying securities directly.
8. The term of a swap equals the maturity of its exposure, in contrast to other OTC transactions, such as options and certain types of forwards, where the contract term and maturity of the underlying security are not related. As a result, there is no restriction under NI 81-102, for example, on a forward referencing an underlying interest having a term of 10 years or more, whereas there is a restriction if the derivative is in the form of a swap.
9. Credit default swaps (CDS) have a similar risk profile to their reference entity (corporate or sovereign bonds), or in the case of an index of credit default swaps (CDX), to an average of all the reference entities in the CDX index. The term of a credit default swap imparts credit risk similar to that of a bond of the reference entity with the same term. The Funds may not be able to achieve the same sensitivity to the credit risk of a specific reference entity or their respective benchmarks by using credit default swaps with a maximum term of three years because the reference entity or relevant benchmark may have an average term that is longer. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).
10. A currency forward used for hedging purposes may or may not have a contract term and maturity that equals the maturity of the underlying interest. For example, if a 10 year bond is denominated in U.S. dollars, under the current provisions of NI 81-102, the term of the currency forward can be at most five years whereas the term of the underlying interest is 10 years. Ideally to manage the currency risk, a fund must enter into two consecutive five-year currency forwards. However, the pricing for the currency forward in respect of the second five year period is not known at the time the U.S. dollar bond is purchased but only five years hence. Consequently, the inability to enter into a 10 year currency forward transaction indirectly introduces currency risk when a hedged 10 year position was the desired outcome. Accordingly, whenever the term of the bond is longer than five years, strict compliance with the current provisions of NI 81-102 may expose a fund to currency risk. This has become a very relevant issue given that there are no longer foreign investment restrictions under theIncome Tax Act (Canada). It should also be noted that it is not market convention to have a transaction with a five year term (subject to a right to eliminate the exposure within three years) as required by NI 81-102 and as a result, from time to time, this off-market feature may subject a fund to less efficient pricing.
11. The interest rate swap market, credit default swap market and currency forward market are very large and liquid.
12. The interest rate swap market is generally as liquid as government bonds and more liquid than corporate bonds. The Bank for International Settlements reported that the notional amount of interest rate swaps outstanding was U.S.$229.8 trillion as of December 31, 2006. In Canada, there were over U.S.$1.9 trillion of interest rate swaps outstanding as of such date, greater than the sum of all outstanding federal and provincial debt.
13. CDS, on average, are highly liquid instruments. Single name CDS are slightly less liquid than the bonds of their reference entities, while CDS on CDX are generally more liquid than corporate or emerging market bonds. The Bank for International Settlements reported that the notional amount of credit default swaps outstanding was U.S.$20.3 trillion as of December 31, 2006. The International Swap and Derivatives Association's 2006 mid-year market survey estimated the notional amount outstanding to be U.S.$26.0 trillion. Using either source, the credit default swap market has surpassed the size of the equity derivatives markets, and is one of the fastest growing financial markets.
14. With respect to foreign exchange, the Bank for International Settlements reported that the notional amount of outright forwards and foreign exchange swaps outstanding was U.S.$19.8 trillion as at December 31, 2006. By comparison, the S&P 500 had an estimated market capitalization of U.S.$13.7 trillion on such date. The Bank for International Settlements also reported that the average daily turnover of OTC foreign exchange was U.S.$1,292 billion during April 2004. The average daily turnover of outright forwards and foreign exchange swaps totaled U.S.$1,152 billion during such period. By comparison, the daily trading during July 2006 was in the case of the New York Stock Exchange approximately U.S.$61.2 billion and in the case of the Toronto Stock Exchange approximately CAD$5.1 billion. Daily trading is many times larger for currencies and currency forwards than for well-known equity exchanges.
15. Because swap and forward contracts are private agreements between two counterparties, a secondary market for the agreements would be a cumbersome process whereby one counterparty would have to find a new counterparty willing to take over its contract at a fair market price, get the original counterparty to approve the new counterparty, and exchange a new set of documents. To avoid that process, market participants can unwind their positions in interest rate swaps and currency forwards by simply entering into an opposing swap with an acceptable counterparty at market value. In this way, the original economic position of the initial swap or forward is offset. In the case of CDS, the Filer would trade with the original counterparty, which has the effect of cancelling the CDS at current prices, or trade with another counterparty by assigning the swap to the other counterparty. Should one of the two remaining parties in the contract default, there is no recourse back to the fund.
16. When entering into swap and forward transactions on behalf of the Funds, the Filer insists on certain conditions in the terms of its agreements. Among other things, these agreements spell out the required credit rating of the counterparty and the process by which the Filer may close out the position, at market price on behalf of the Funds.
17. Credit risk exposure to a counterparty on an interest rate swap transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102.
18. Potential credit exposure to a counterparty on a credit default swap depends on the role of each counterparty. When the fund is the protection buyer -- ie entering in to the CDS in order to reduce its exposure to the underlying debt -- its potential credit exposure to the counterparty is equal to the entire notional amount of the underlying debt. If there is a default of the underlying debt, the counterparty would have to make a payment under the swap, which is dependent on its ability to make that payment. However if the fund is a protection seller -- ie entering in to the swap in order to gain additional exposure to the debt -- the fund would receive periodic payments from the counterparty, and consequently its credit exposure to the counterparty is limited to the value of the payments not received and the cost of re-establishing the position with another counterparty. As is the case with interest rate swaps, this exposure, in either case, is mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102 and exposure to any individual counterparty is limited by NI 81-102.
19. As is the case with interest rate swaps, credit risk exposure to a counterparty is only a small fraction of the underlying notional exposure of a currency forward. The Bank for International Settlements estimated as at December 31, 2006 that the "gross market value" of outright forwards and foreign exchange swaps was approximately 2.4% of the notional amount.
20. By permitting the Funds to enter into swaps beyond three year terms, it increases the possibility for the Funds to increase returns due to the fact that the opportunity set is expanded and to target exposures that might not otherwise be available in the cash bond markets or could not be achieved as efficiently as in the cash bond markets. Further, the use of swaps and forwards beyond three year terms enables the Funds to effect hedging transactions that help mitigate underlying investment risks.
21. The Filer has the right to terminate the swap or forward early if a counterparty's credit rating drops below the credit ratings established by NI 81-102. In connection with the Funds, the Filer will do so in accordance with the requirements of section 2.7(4) of NI 81-102 and the definition of "approved credit rating" in NI 81-102.
Using Fixed Incomes Securities and Floating Rate Debt as Cover
22. Section 2.8 of NI 81-102 requires in some cases that mutual funds cover their derivative positions with "cash cover". The current definition of "cash cover" in NI 81-102 includes:
(a) commercial paper that has a term to maturity of 365 days or less and an approved credit rating and that was issued by a person or company other than a government for permitted supranational agency; and
(b) cash equivalent that is an evidence of indebtedness with a remaining term to maturity of 365 days or less, and that is issued, or fully and unconditionally guaranteed as to principal and interest, by government entities that are listed in the definition of "cash equivalent" as defined in NI 81-102.
23. The purpose of the cash cover requirement in NI 81-102 is to limit a mutual fund from leveraging its assets when using certain specified derivatives under section 2.8 and to ensure that the mutual fund is in a position to meet its obligations on the settlement date.
24. The Filer proposes to use liquid fixed income securities and floating rate evidences of indebtedness as cover for specified derivative transactions with respect to the Funds.
25. While money market instruments which are required by NI 81-102 as cash cover are highly liquid, the price paid for that liquidity comes in the form of very low yields relative to longer dated instruments and even relative to similar risk alternatives.
26. The definition of "cash cover" addresses regulatory concerns of interest rate risk and credit risk by limiting the term of the instruments and requiring the instruments to have an approved credit rating. The Filer submits that by permitting the use of fixed income securities with a remaining term to maturity of 365 days or less and an approved credit rating as cover for specified derivative transactions with respect to the Funds, the regulatory concerns are met since the term and credit rating will be the same as other instruments currently permitted as use as "cash cover". Further, the longer dated instruments will enhance yields for the Funds.
27. Floating rate evidences of indebtedness, also known as floating rate notes (FRNs), are debt securities issued by the federal or provincial governments, Crown corporations or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days. However, the term to maturity of FRNs can be more than 365 days.
28. The Filer proposes to meet the cash cover requirement in section 2.8 of NI 81-102 by investing in FRNs that have a remaining term to maturity of more than 365 days and with interest rates that reset no longer than every 185 days.
29. The Filer submits that the use of FRNs as cash cover can enhance the return of the Funds without reducing the quality of "cash cover" for the purposes of specified derivatives.
30. For the purposes of "money market funds" (as defined in NI 81-102) meeting the 90 day dollar-weighted average term to maturity, the term of a floating rate evidence of indebtedness is the period remaining to the date of the next rate setting.
31. The Filer considers there to be minimal interest rate risk associated with FRNs as floating interest rates generally reset on a short term basis, such as every 30 days to 90 days. Credit risk aside, if an FRN resets every 365 days, then the interest rate risk of the FRN is about the same as a fixed rate instrument with a term to maturity of 365 days.
32. Further, financial instruments that meet the current "cash cover" requirement 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 FRNs is an entity other than a government agency, the FRNs will have an approved credit rating as required in NI 81-102.
33. FRNs will have adequate liquidity and will otherwise meet the requirement for derivative transactions carried out in accordance with section 2.8.
Using Put Options or Short Futures Positions as Cover for Long Positions in Futures, Forwards and Swaps
34. Sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 do not permit covering long positions in futures and forwards and long positions in swaps 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. In other words, these provisions do not permit the use of put options or short future positions to cover long future, forward or swap positions.
35. Strict compliance with the requirements of 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, while NI 81-102 requires cash collateral to cover both the long position and the offsetting short position. Over-collateralization imposes various costs on a Fund including opportunity costs that arise when a Fund cannot invest assets designated as collateral to earn a return.
36. 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 and therefore, the Filer submits that the Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future position.
37. The Filer has written policies and procedures relating to the use of derivatives for the Funds that implement a risk management system with respect to such activities. These policies and procedures are approved by the Board of Directors of the Filer.
38. The Head of the Fixed Income Department of the Filer or his or her designate is responsible for derivatives activities for this department. The responsibility for oversight of the firm's derivatives program generally rests with the Head of the Fixed Income Department and the Head of the North American Equities Department of the Filer (or their designates) and any matters of concern must be brought to the attention of the Board of Directors and the Risk Management Committee of the Filer.
39. The Risk Management Committee of the Filer reviews and approves the specific derivative strategies that have been developed by individual investment analysts and portfolio managers in the Fixed Income Department, and monitors the status of the derivatives positions in the Funds.
40. Comprehensive administrative procedures and controls have been implemented to mitigate the risks associated with derivative investments. These include procedures and controls over (a) the dealers and counterparties with which the Filer and the Funds execute transactions, (b) the employees of the Filer initiating, recording and monitoring derivative transactions, and (c) the documentation of each transaction.
41. Limits and controls on the use of derivatives are part of the Filer's fund risk and compliance regime. Department heads or designated derivative supervisors of the Fixed Income Department are required to sign off on each type of proposed derivative product and strategy used by a Fund and two signatures are required on all derivative trade tickets. An analyst that reports to the Risk Management Committee ensures that the derivative positions of each Fund are within applicable policies. Derivative positions are monitored daily.
42. The derivative contracts entered into by the Filer or sub-advisor on behalf of the Funds must be in accordance with the investment objectives and strategies of each of the Funds. The Filer is also required to adhere to NI 81-102. The Filer sets and reviews the investment policies of the Funds, which also allows the trading in derivatives.
43. The prospectuses and annual information forms of the Funds disclose the internal controls and risk management processes of the Filer regarding the use of derivatives and, upon renewal, will include disclosure of the nature of the relief granted in respect of the Funds.
Each of the Decision Makers is satisfied that the test contained in the Legislation that provides the Decision Maker with the jurisdiction to make the Decision has been met. The decision of the Decision Makers under the Legislation is that the Requested Relief 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 FRNs meet the following requirements:
(i) the floating interest rates of the FRNs reset no later than every 185 days;
(ii) the FRNs 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 FRNs are issued by a person or company other than a government or "permitted supranational agency" as defined in NI 81-102, the FRNs must have an "approved credit rating" as defined in NI 81-102;
(iv) if the FRNs are issued by a government or permitted supranational agency, the FRNs have their principal and interest fully and unconditionally guaranteed by (A) the government of Canada or the government of a jurisdiction in Canada; or (B) 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 supranational agency" as defined in NI 81-102, if, in each case, the FRN has an "approved credit rating" as defined in NI 81-102; and
(v) the FRNs meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
(c) a Fund does 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 a) and b) 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 does not enter into or maintain a swap position unless for periods when the Fund would be entitled to receive 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 clauses a) and b) that is sufficient, without recourse to other assets of the Fund, to enable the Fund to satisfy its obligations under the swap; and
(e) at the time of the next renewal and all subsequent renewals of the prospectus and annual information form of the Funds and/or the Funds, each of the Funds and the Funds shall disclose the nature of this relief in each fund's prospectus under the Investment Strategies section and the nature and terms of the relief in the fund's annual information form.
List of Funds