Sovereign Canadian Equity Pool et al. - MRRS Decision

Headnote

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: bonds, debentures, notes, other evidences of indebtedness and securities of money market funds; 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), 2.8(1)(d), 2.8(1)(f)(i), 19.1.

October 23, 2006

IN THE MATTER OF

THE SECURITIES LEGISLATION OF

BRITISH COLUMBIA, ALBERTA, SASKATCHEWAN,

MANITOBA, ONTARIO, QUÉBEC, NEW BRUNSWICK,

NOVA SCOTIA, NEWFOUNDLAND AND LABRADOR,

PRINCE EDWARD ISLAND, NORTHWEST

TERRITORIES, NUNAVUT and YUKON

(the "Jurisdictions")

AND

IN THE MATTER OF

THE MUTUAL RELIANCE REVIEW SYSTEM

FOR EXEMPTIVE RELIEF APPLICATIONS

AND

IN THE MATTER OF

SOVEREIGN CANADIAN EQUITY POOL

SOVEREIGN US EQUITY POOL

SOVEREIGN OVERSEAS EQUITY POOL

SOVEREIGN GLOBAL EQUITY POOL

SOVEREIGN EMERGING MARKETS EQUITY POOL

SOVEREIGN CANADIAN FIXED INCOME POOL

RUSSELL CANADIAN FIXED INCOME FUND

RUSSELL CANADIAN EQUITY FUND

RUSSELL US EQUITY FUND

RUSSELL OVERSEAS EQUITY FUND

RUSSELL GLOBAL EQUITY FUND

(the "Existing Funds")

AND

RUSSELL INVESTMENTS CANADA LIMITED

(the "Filer")

MRRS DECISION DOCUMENT

Background

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") granting relief from the requirements set out in Sections 2.7(1)(a) and 2.8(1) of National Instrument 81-102 ("NI 81-102") in order to permit each Existing Fund and such other mutual funds (except for money market funds) for which the Filer may, in the future, become the manager (together with the Existing Funds, the "Funds") to:

(a) cover specified derivative positions with:

(i) any bonds, debentures, notes or other evidences of indebtedness that are liquid ("Fixed Income Securities");

(ii) floating rate evidences of indebtedness ("FRNs"); or

(iii) securities of money market funds managed by the Manager to which NI 81-102 applies ("Money Market Funds");

(b) use as cover, a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap when:

(i) it opens or maintains 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) it enters into or maintains an interest rate swap position and during the periods when the Fund is entitled to receive payments under the swap; and

(c) enter into interest rate swaps and credit default swaps ("CDSs") with a remaining term to maturity of greater than 3 years.

(the "Requested Relief").

Under the Mutual Reliance Review System for Exemptive Relief Applications:

(a) the Ontario Securities Commission is the principal regulator for this application; and

(b) this MRRS decision document evidences the decision of each Decision Maker.

Interpretation

Defined terms contained in National Instrument 14-101 Definitions or NI 81-102 have the same meaning in this decision unless they are defined in this decision.

Representations

This decision is based on the following facts represented by the Filer:

1. The Filer is the manager of each Fund for purposes of NI 81-102. The Filer is registered under the Securities Act (Ontario) as an advisor in the categories of investment counsel and portfolio manager and under the Commodity Futures Act (Ontario) as a commodity trading manager.

2. Each Fund is a mutual fund that offers, or has offered, its securities by a prospectus in all the Jurisdictions. Each Fund is a reporting issuer (or the equivalent) under the securities legislation of the Jurisdictions and is subject to the requirements of NI 81-102.

3. The investment objectives and strategies of each Fund permit the Fund to invest a portion of its assets in Fixed Income Securities and to use derivative instruments (including CDSs) to gain exposure to securities and markets instead of investing in the securities directly. Each Fund also may use derivative instruments to reduce risk by protecting the Fund against potential losses from changes in interest rates and reducing the impact of currency fluctuations on the Fund's portfolio holdings. When a Fund uses specified derivatives for non-hedging purposes, the Fund is subject to the cash cover requirement of NI 81-102.

4. The Filer retains investment managers (the "Investment Managers") to manage specific portions of the assets of each Fund according to a mandate (a "Mandate") established between the Filer and each Investment Manager. The Mandates permit the Investment Managers to use derivatives in accordance with the investment objectives and strategies of the Funds and the requirements of NI 81-102. Each Investment Manager is required to have written policies and procedures in place on the use of derivatives as investments within the Funds. These policies and procedures must set out specific procedures for the authorisation, documentation, reporting, monitoring and review of derivative strategies and positions, which policies and procedures must be reviewed at least annually by each Investment Manager. The Filer also requires that each Investment Manager use risk management processes to monitor and measure the risks of all portfolio holdings, including the derivatives positions in the Funds. The Investment Managers use risk measurement procedures or simulations to test the derivatives holdings of the Funds under stress, where applicable. The Filer is responsible for the investment advice that the Investment Managers provide to the Funds.

5. The Filer has its own written investment guidelines relating to the use of derivatives (the "Filer's Guidelines"). The Filer's Guidelines are reviewed on an ongoing basis by senior members of the portfolio management group of the Filer. The Chief Investment Officer of the Filer is responsible for oversight of all derivative strategies permitted by the Funds. In addition, compliance personnel employed by the Filer review the use of derivatives by the Funds as part of their ongoing review of Fund activity. Setting limits and controls on the use of derivatives by the Funds are part of the Filer's Fund compliance regime and include reviews and monitoring by analysts who ensure that the derivative positions of the Funds are within such limits and controls.

6. Strategies currently employed by some Investment Managers from time to time in managing investment portfolios of their other clients in the United States and European jurisdictions are currently prohibited by NI 81-102. The inability of the Investment Managers to use such strategies for the Funds deprives investors in the Funds of the benefits of a more efficient, cost-effective and diversified portfolio.

7. The Requested Relief will be in the best interests of the Funds as it should lead to cost savings, potentially enhance the performance of the Funds and will not leave the Funds exposed to any material incremental risk beyond the risk that the Filer is targeting and is consistent with the investment objectives and strategies of the Funds. Without these exemptions, the Funds will not have the flexibility to enhance yield and to manage more effectively the exposures under specified derivatives.

8. 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.

9. Throughout the period that each Fund relies on the Requested Relief, the Fund's then current prospectus will disclose the nature of the Requested Relief and that the Fund will be managed consistent with the Requested Relief.

Using Fixed Income Securities, Floating Rates Notes and Money Market Funds as Cash Cover

10. 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 or 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 full 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,

(collectively, "short-term debt").

Fixed Income Securities

11. 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. 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 with allowing Fixed Income Securities to be used as cash cover are met since the term and credit rating will be the same as other instruments currently permitted for use as "cash cover". Further, the longer dated instruments will enhance yields for the Funds.

FRNs

12. 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.

13. For purposes of meeting the cash cover requirement in section 2.8 of NI 81-102, the Funds will invest only 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. The use of FRNs as cash cover can enhance the returns of the Funds without reducing the quality of "cash cover" for the purposes of specified derivatives.

14. There is considered 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 or less, 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.

15. 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 an FRN is an entity other than a government agency, the FRN will have an approved credit rating as required in NI 81-102.

16. Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of FRNs, the risk profile and the other characteristics of FRNs are similar to those of short-term debt, which constitutes cash cover under NI 81-102. FRNs will have adequate liquidity and will otherwise meet the requirement for derivative transactions carried out in accordance with section 2.8.

Money Market Funds

17. In order to qualify as "money market funds" under NI 81-102, the Money Market Funds are essentially restricted to investments that are considered to be cash cover. These investments include FRNs if their principal amounts continue to have a market value of approximately par at the time of each change in the rate to be paid to their holders. If the direct investments of the Money Market Funds would constitute cash cover under NI 81-102, then indirectly holding these investments through an investment in securities of Money Market Funds also should satisfy the cash cover requirements of NI 81-102 and may increase the returns on that portion of the assets of each Fund set aside as cover for specified derivative positions.

18. Having the opportunity to pool the money market instruments of the Funds (whether held as cover for specified derivative positions or otherwise) in the Money Market Funds may lead to better yields for all of the Funds.

Using Put Options as Cover for Long Positions in Futures, Forwards and Swaps

19. Regulatory regimes in other countries recognize the hedging properties of options for all categories of derivatives, including long positions evidenced by standardized futures or forwards or in respect of swaps where a fund is entitled to receive payments from the counterparty, provided they are covered by an amount equal to the difference between the market price of a holding and the strike price of the option that was bought or sold to hedge it. NI 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the mutual fund under the scenario described is equal to the difference between the market value of the long and the exercise price of the option. Overcollateralization imposes a cost on a mutual fund.

20. Section 2.8(1)(c) 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 Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future position.

Interest Rate and Credit Default Swaps

21. The added flexibility given to the Funds to enter into interest rate swaps and CDSs without a restriction as to term of the swap will be particularly beneficial to Funds that are seeking quick and cost effective exposure and diversification for a relatively small amount of fixed income assets.

22. Both the interest rate swap market and CDS market are very large and generally very liquid. Single name CDSs are slightly less liquid than the bonds of their reference entities, while CDSs on an index of credit default swaps (a "CDX") are generally more liquid than corporate or emerging markets bonds. A CDX is linked to a number of the most highly liquid CDSs and therefore permits quick and cost effective diversification to high yield and emerging market issuers.

23. The term of a CDS imparts credit risk similar to that of a bond of the reference entity with the same term. Absent the Requested Relief, the Funds will not be able to achieve the same sensitivity to credit risk as the CDXs by using credit default swaps with a maximum term of three years because the average term of CDSs included in a CDX typically is much longer than three years. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).

24. Permitting the Funds to enter into swaps beyond three year terms will increase the possibility for the Funds to increase returns due to an expanded opportunity set of swaps and enables the Funds to target exposure 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, it enables the Funds to effect hedging transactions that are more efficient and tailored.

25. As part of its Mandate, each Investment Manager can enter into swap transactions on behalf of the Funds only in compliance with certain conditions relating to creditworthiness of the counterparty. Credit risk exposure to a counterparty on a swap transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap (less any collateral posted by the counterparty). If the Requested Relief is granted, any incremental risk associated with swaps having extended terms to maturity will be adequately mitigated because:

(a) the counterparty must be approved by the Investment Manager and have an approved credit rating prescribed by NI 81-102; and

(b) the Investment Manager will terminate the swap transaction immediately if the counterparty ceases to have an approved credit rating.

Decision

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:

1. 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;

2. the FRNs meet the following requirements:

(a) the floating interest rates of the FRNs reset no later than every 185 days;

(b) 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;

(c) 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 have an "approved credit rating" as defined in NI 81-102;

(d) if the FRNs are issued by a government or permitted supranational agency, the FRNs have their principal and interest fully and unconditionally guaranteed by:

(i) the government of Canada or the government of a jurisdiction in Canada; or

(ii) 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

(e) the FRNs meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;

3. the Money Market Funds are subject to NI 81-102;

4. a Fund shall 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:

(a) cash cover including Fixed Income Securities, FRNs and securities of Money Market Funds as permitted by this Decision (collectively, the "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;

(b) a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and 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

(c) a combination of the positions referred to in paragraphs (a) and (b) immediately above 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;

5. a Fund shall not enter into or maintain an interest rate swap position unless for periods when the Fund would be entitled to receive payments under the swap, the Fund holds:

(a) 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;

(b) a right or obligation to enter into an offsetting interest rate swap on an equivalent quantity and with an equivalent term and 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 interest rate swap less the obligations of the Fund under such offsetting interest rate swap; or

(c) a combination of the positions referred to in paragraphs (a) and (b) immediately above that is sufficient, without recourse to other assets of the Fund, to enable the Fund to satisfy its obligations under the interest rate swap; and

6. a Fund shall not enter into an interest rate swap or CDS with a remaining term to maturity of greater than 3 years unless such an interest rate swap or CDS is permitted by the investment objectives and strategies of the Fund;

7. the Funds disclose the nature and terms of this relief in the Funds' prospectus under the Investment Strategies section, or in the introduction to Part B of the prospectus with a cross-reference thereto under the Investment Strategies section, and in the Funds' annual information form.