Approval of mutual fund reorganization -- approval required because merger does not meet the criteria for pre-approval -- merger of labour sponsored investment funds -- merger is not a "qualifying exchange" or a tax-deferred transaction under the Income Tax Act -- securityholders provided with timely and adequate disclosure regarding the mergers.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 5.5(1)(b), 5.6(1)(a) & (b), 19.1.
November 1, 2013
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
IN THE MATTER OF
COVINGTON STRATEGIC CAPITAL FUND INC.
(THE SELLING FUND)
COVINGTON CAPITAL CORPORATION
(THE COVINGTON MANAGER)
The Ontario Securities Commission has received an application from the Selling Fund for a decision under the securities legislation of the Jurisdiction (the Legislation) for approval pursuant to subsection 5.5(1)(b) of National Instrument 81-102 Mutual Funds (NI 81-102) for the sale of assets of the Selling Fund to Covington Fund II Inc. (Covington Fund II) which would result in securityholders of the Selling Fund becoming securityholders of Covington Fund II (the Approval Sought).
Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are otherwise defined in this decision.
The decision is based on the following facts represented by the Selling Fund:
The Selling Fund
1. The Selling Fund is not in default of securities legislation in the Jurisdiction.
2. The Selling Fund was incorporated on November 18, 2003 under the Business Corporations Act (Ontario) (the OBCA).
3. The Selling Fund is registered as a labour sponsored investment fund corporation (LSIF) under the Community Small Business Investment Funds Act (Ontario) (the CSBIF Act) and is a prescribed labour-sponsored venture capital corporation (LSVCC) under the Income Tax Act (Canada) (the Tax Act). The Selling Fund's investment activities are governed by the CSBIF Act.
4. The Selling Fund is a reporting issuer in Ontario only.
5. The fundamental investment objective of the Selling Fund is to achieve long-term capital appreciation through investment in a diversified portfolio of private and public technology companies which qualify as "eligible businesses" under the CSBIF Act.
6. The manager of the Selling Fund is the Covington Manager.
7. The labour sponsor of the Selling Fund is the Canadian Police Association (the CPA).
Covington Fund II
8. Covington Fund II was incorporated under the OBCA by articles of incorporation dated September 20, 1999 and was continued under the Canada Business Corporations Act (CBCA) by articles of continuance dated November 25, 2010. The articles of Covington Fund II were amended by articles of amendment dated November 29, 2010 and September 1, 2011.
9. Covington Fund II is a registered LSIF under the CSBIF Act and by virtue of a prior transaction is a registered LSVCC under the Tax Act. Covington Fund II's investment activities are governed by the CSBIF Act and the Tax Act.
10. Covington Fund II is a reporting issuer in all of the Provinces and Territories of Canada.
11. The fundamental investment objective of Covington Fund II is to earn long-term capital appreciation on part of its investment portfolio and current yield and early return of capital on the remainder of its investment portfolio through investment in common shares, convertible preference shares or other instruments which create a right to acquire common shares, debt (with or without conversion features), warrants and other securities of both early stage, high growth companies as well as established businesses.
12. The manager of Covington Fund II is the Covington Manager.
13. The labour sponsors of Covington Fund II are the CPA and the Association of Canadian Financial Officers.
14. The shareholders of the Selling Fund passed a special resolution approving the Transaction (as defined below) at a shareholders' meeting held on October 24, 2013 (the Shareholders' Meeting).
15. The board of Covington Fund II has concluded, based largely on the relative sizes of the Selling Fund and Covington Fund II, that the Transaction is not material to Covington Fund II and has approved the Transaction at a meeting of the board of directors.
16. Details of the proposed sale of assets of the Selling Fund which would result in shareholders of the Selling Fund becoming shareholders of Covington Fund II (the Transaction) were contained in information circular dated September 27, 2013 (the Circular) sent by the Selling Fund to its shareholders, which Circular contains details of the Transaction, including income tax considerations associated with the Transaction. A copy of the Circular was filed on SEDAR on October 2, 2013.
17. In accordance with National Instrument 81-106 Investment Fund Continuous Disclosure, a press release announcing the Transaction was filed on SEDAR on September 19, 2013. A material change report of the Selling Fund was filed on SEDAR on September 20, 2013.
18. The board of Covington Fund II has proposed an asset purchase agreement (the APA) setting out the terms and conditions of the Transaction for consideration by the shareholders' of the Selling Fund at the Shareholders' Meeting in connection with their consideration of the Transaction. A copy of the APA is attached to the Circular filed on SEDAR.
19. The APA will be entered into by Covington Fund II and the Selling Fund, and the Transaction will be expected to close on a date (the Closing Date) to be determined by the Covington Manager, currently expected to be on or about November 1, 2013.
20. Pursuant to National Instrument 81-107 Independent Review Committee for Investment Funds, the independent review committee (IRC) has reviewed the Transaction on behalf of the Selling Fund and Covington Fund II, and has advised the Covington Manager that in the IRC's opinion, having reviewed the Transaction as a potential conflict of interest, the Transaction achieves a fair and reasonable result for the Selling Fund and Covington Fund II.
21. On the Closing Date, Covington Fund II will issue Class A shares, Series I (the Transaction Shares), as described in the Circular, to the Selling Fund on a prospectus exempt basis pursuant to section 2.11 of National Instrument 45-106 Prospectus and Registration Exemptions in exchange for the assets of the Selling Fund. The number of Transaction Shares issued to the Selling Fund will be determined by reference to the net asset value of the Selling Fund (as determined in accordance with the Selling Fund's valuation policies and procedures) as at the Closing Date. The remaining distribution service fees owed by the Selling Fund to the Covington Manager will be paid so that all shareholders' of the Selling Fund will receive Class A shares, Series I of Covington Fund II.
22. No sales charges will be payable in connection with the acquisition by Covington Fund II of the investment portfolio of the Selling Fund.
23. Pursuant to the redemption procedure for the redemption of Class A Shares of the Selling Fund approved by the shareholders of the Selling Fund as part of the special resolution passed at the Shareholders' Meeting, the Selling Fund will redeem its Class A shares in exchange for the Transaction Shares received by the Selling Fund.
24. Upon closing, the shareholders of the Selling Fund will receive an equivalent value of Transaction Shares in payment for the Class A shares of the Selling Fund held by each such shareholder on the Closing Date. The number of Transaction Shares delivered in payment of the redemption price of the redeemed Class A shares of a shareholder of the Selling Fund will be equal to the number of Class A shares of the Selling Fund held by the shareholder multiplied by the "Exchange Ratio". For the purposes of the foregoing, the Exchange Ratio equals the Transaction NAV per Share of the Selling Fund's Class A shares divided by the Transaction NAV per Share of the Transaction Shares where "Transaction NAV per Share" means:
(a) The NAV of a fund (as determined in accordance with that fund's valuation policies and procedures and adjusted as necessary to account for any proceeds to be paid under any dissent rights) as at the Closing Date allocated to each series of Class A shares of that fund; divided by
(b) The number of outstanding Class A shares of that series of that fund (adjusted for shareholders exercising dissent rights) as of the Closing Date.
25. The costs and expenses specifically associated with the Transaction will be borne by the Covington Manager.
26. Redemptions of Class A shares of Covington Fund II and the Selling Fund are currently occurring without suspension, which situation is proposed to continue throughout the completion of the Transaction. Shareholders of the Selling Fund will continue to have the right to redeem securities of the Selling Fund up to the close of business immediately before the effective date of the Transaction. Upon completion of the Transaction, holders of Class A shares of Covington Fund II and the Selling Fund will not be subject to any new redemption fees or redemption restrictions on their Class A shares of Covington Fund II.
27. All redemptions will also be subject to tax credit recapture withholdings under the CSBIFA or the Tax Act and applicable deferred sales commissions if Class A shares are redeemed at a date when they have been issued for less than eight years. The Transaction qualifies as a business combination within the meaning of section 27.1 of the CSBIF Act and as such each Transaction Share will be deemed to have an issue date that is the same date as the issue date of the Class A share which such Transaction Share replaced. The Transaction also qualifies as a merger for purposes of subsection 204.85(3) of the Tax Act such that, for certain purposes of the provisions of the Tax Act relating to LSVCCs and the holders of the Transaction Shares, the Transaction Shares will be deemed to be issued at the time the Selling Fund issued the Class A Share which the Transaction Share replaced.
28. The Covington Manager estimates that approximately 99% of the shareholders of the Selling Fund hold their Class A Shares in a registered account and, as such, would not pay tax on any gain they might receive as a result of the transaction.
29. The Covington Manager will continue to serve as manager for Covington Fund II.
30. Upon completion of the Transaction, the existing management agreement and servicing agreement between the Selling Fund and Covington Manager shall be terminated without compensation to Covington Manager and the distribution service fees for the Selling Fund will be prepaid as described below.
31. Shareholders of the Selling Fund are expected to benefit from the increased scale and operational efficiencies of Covington Fund II, enjoying the same or lower management fees, and the ongoing right to redeem from the Selling Fund if the shareholder does not choose to participate in the Transaction.
32. A distribution services fee is payable to the Covington Manager in respect of the Selling Fund. The Covington Manager is responsible for managing the relationships with registered dealers selling the Class A shares of the Selling Fund. Prior to the cessation of new sales of Class A shares by the Selling Fund, the Covington Manager financed the payment of a 10% sales commission to such dealers in respect of sales of Class A shares, Series I sold prior to December 27, 2010 and a 6% sales commission to such dealers in respect of sales of Class A shares, Series II sold prior to December 19, 2011. The Covington Manager is remunerated for this service through a monthly fee of 0.160% of the original issue price of the Class A shares, Series I (1.92% annually) and a monthly fee of 0.096% of the original issue price of the Class A shares, Series II (1.15% annually) which are still outstanding during that month. In the event that such shares are redeemed prior to the eighth anniversary of the date of their issue, the Selling Fund charges redeeming shareholders a fee equal to 1.25% of the original issue price for Class A Shares, Series I times the number of years until the eighth anniversary of the sale of the shares and 0.75% of the original issue price for Class A shares, Series II times the number of years until the eighth anniversary of the sale of the shares. The Selling Fund pays this redemption fee to the Covington Manager in lieu of the monthly fee on such redeemed shares. In merging the Selling Fund with Covington Fund II, only Class A shares, Series I of Covington Fund II are being issued and in respect of which no distribution service fees are paid. Investors who receive Transaction Shares will no longer be subject to the distribution services fees since the remaining distribution service fees will be prepaid as part of the Transaction and such pre-payment will be reflected in the Exchange Ratio.
33. The pre-payment of the distribution service fees on the transaction will result in the payment of the principal amount of the sales commissions in respect of which the distribution service fee is calculated, rather than the full distribution service fee otherwise payable by the Selling Fund over the next four years in respect of those sales commissions. This will result in the Selling Fund paying approximately $207,000 rather than approximately $311,000 in remaining distributions service fees anticipated to be due over the next four years. This will represent a savings of approximately $104,000 for the benefit of the Class A Shareholders of the Selling Fund.
34. Based on current projections of Covington Fund II, including the fact that the MER of Class A Shares, Series I is estimated to be approximately 1.34% per annum lower than the MER of Class A Shares, Series II on account of the lack of distribution service fees, the Class A shareholders of the Selling Fund could be expected to incur approximately $269,000 in additional management expenses over the next four years if they received Class A Shares, Series II of Covington Fund II and continued to pay distribution service fees over the next four years. The pre-payment of the distribution service fees of approximately $207,000 and the issue of Class A Shares, Series I of Covington Fund II will represent a savings of approximately $62,000 for the benefit of the Class A Shareholders of the Selling Fund.
35. After the Selling Fund redeems all Class A shares, the Class B shares will be the only outstanding shares of the Selling Fund.
36. The Selling Fund will retain the Covington Manager for the purpose of winding up the Selling Fund as soon as reasonably possible after the Closing Date.
37. The CPA has agreed, upon completion of the Transaction, that it will execute an agreement with the Selling Fund which will terminate its sponsorship agreement and facilitate the wind-up of the Selling Fund without further compensation payable to the CPA over the fees due to the Closing Date. There will be no change to the existing sponsorship arrangement of Covington Fund II.
38. Under Section 5.5(1)(b) of NI 81-102, the Selling Fund is required to obtain the approval of the securities regulatory authority or regulator where a transfer of its assets is implemented, if the transaction will result in the securityholders of a Selling Fund becoming securityholders in another mutual fund. Each securityholder of the Selling Fund would, as a result of the Transaction, become a securityholder of Covington Fund II.
39. Section 5.6(1) of NI 81-102 sets out the circumstances in which a mutual fund need not obtain the approval of the securities regulatory authority or regulator under Section 5.5(1)(b). Section 5.6 cannot be relied upon because the Transaction is not a "qualifying exchange" within the meaning of Section 132.2 of the Tax Act as it does not involve a transfer of property of the Selling Fund to a mutual fund trust. The Transaction will not be a tax-deferred transaction under subsection 85(1), 85.1(1), 86(1) or 87(1) of the Tax Act. The directors of the Selling Fund have concluded that all other conditions for the reliance on Section 5.6(1) have been met.
40. Shareholders of Covington Fund II will not be subject to tax as a result of the Transaction.
41. Shareholders of the Selling Fund who hold their Class A shares in a registered plan, such as an RRSP or RRIF, will not pay any income tax as a result of the redemption of their Class A shares pursuant to the Transaction.
42. Shareholders of the Selling Fund who hold their Class A shares outside a registered account may realize a capital gain or a capital loss as a result of the Transaction. Details of the tax considerations for the Selling Fund's shareholders are described in the Circular.
43. The Transaction qualifies as a business combination within section 27.1 of the CSBIF Act and as such each Transaction Share will be deemed to have an issue date that is the same date as the issue date of the Class A share which such Transaction Share replaced. The Transaction also qualifies as a merger for purposes of subsection 204.85(3) of the Tax Act such that, for certain purposes of the provisions of the Tax Act relating to LSVCCs, the Transaction Shares will be deemed to be issued at the time the Selling Fund issued the Class A Share which the Transaction Share replaced.
The regulator is satisfied that the decision meets the test set out in the Legislation for the regulator to make the decision.
The decision of the regulator under the Legislation is that the Approval Sought is granted.