NP 11-203 – Relief granted from the requirement in section 6.1 of NI 81-102 that all portfolio assets of an investment fund must be held under the custodianship of one custodian – Relief needed because plain reading of exemption in section 6.8.1 of NI 81-102 from the requirement in section 6.1 of NI 81-102 results in unintended consequences – Relief subject to condition that the aggregate market value of the securities held by the Prime Broker after such deposit excluding the aggregate of the market value of the proceeds from all then outstanding short sales of securities, must not, (a) in the case of a Fund, other than an Alternative Fund, exceed 10% of the net asset value of the Fund at the time of deposit, and (b) in the case of an Alternative Fund, exceed 25% of the net asset value of the Alternative Fund at the time of deposit.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 6.1, 6.8.1, and 19.1.
August 16, 2019
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS
IN MULTIPLE JURISDICTIONS
IN THE MATTER OF
FIDELITY INVESTMENTS CANADA ULC
FIDELITY NORTH AMERICAN DIRECTIONAL LONG SHORT FUND
(the Proposed Fund)
The principal regulator in the Jurisdiction has received an application from the Filer, which is the trustee and the investment fund manager of the Proposed Fund, for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) for an exemption, pursuant to section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102), for the Proposed Fund and all other current and future mutual funds, exchange-traded funds and alternative mutual funds managed by the Filer or an affiliate of the Filer (the Future Funds and, together with the Proposed Fund, the Funds) exempting each Fund from the requirement set out in subsection 6.1(1) of NI 81-102 that provides that, except as provided in section 6.8, 6.8.1 and 6.9, all portfolio assets of an investment fund must be held under the custodianship of one custodian that satisfies the requirements of section 6.2, in order to permit the following:
(i) unless the borrowing agent is the Fund’s custodian or sub-custodian, if a Fund deposits portfolio assets with a borrowing agent as security in connection with a short sale of securities, the aggregate market value of portfolio assets held by the borrowing agent after such deposit, excluding the aggregate market value of the proceeds from outstanding short sales of securities held by the borrowing agent, must not:
(a) in the case of each Fund, other than an Alternative Fund, exceed 10% of the net asset value of the Fund at the time of deposit; and
(b) in the case of an Alternative Fund, exceed 25% of the net asset value of the Alternative Fund at the time of deposit
(collectively, the Requested Relief).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission (OSC) is the principal regulator for the application; and
(b) the Filer has provided notice that Section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Northwest Territories, Nova Scotia, Nunavut, Prince Edward Island, Québec, Saskatchewan and Yukon (together with Ontario, the Jurisdictions).
Terms defined in National Instrument 14-101 Definitions and MI 11-102 have the same meaning if used in this decision, unless otherwise defined. The following terms shall have the following meanings:
Alternative Fund means each Fund, including the Proposed Fund, that is or will be an alternative mutual fund under NI 81-102
Prime Broker means any entity that acts as, among other things, a borrowing agent to one or more investment funds, whether the investment fund is an alternative mutual fund, a mutual fund or an exchange-traded fund
Security Agreement means the agreement under which an investment fund provides a security interest over some or all of its portfolio assets in favour of a Prime Broker, which includes, without limitation, any applicable prime brokerage agreement and any other similar document between the investment fund and the Prime Broker that creates a security interest in favour of the Prime Broker
This decision is based on the following facts represented by the Filer:
- The Filer is a corporation continued under the laws of the Province of Alberta with its head office located in Toronto, Ontario.
- The Filer is registered as an investment fund manager in Ontario, Québec and Newfoundland and Labrador, as a portfolio manager in each of the Jurisdictions, as a commodity trading manager in Ontario and as a mutual fund dealer in each of the Jurisdictions.
- The Filer is, or will be, the investment fund manager of the Funds and the Filer, an affiliate of the Filer or a third party portfolio manager retained by the Filer is, or will be, the portfolio manager of the Funds.
- The Filer is not in default of securities legislation in any of the Jurisdictions.
- The Proposed Fund is, or will be, an alternative mutual fund governed by the laws of Ontario.
- The Funds are, or will be, open-ended mutual funds or classes of a mutual fund corporation, including exchange-traded funds and alternative mutual funds, organized and governed by the laws of a Jurisdiction or the laws of Canada.
- The Funds are, or will be, governed by the provisions of NI 81-102, subject to any exemption therefrom that has been, or may be, granted by the securities regulatory authorities.
- As part of its investment strategies, the Proposed Fund will enter into specified derivatives transactions, borrow cash and/or sell short securities, provided that, in accordance with section 2.9.1 of NI 81-102, the Proposed Fund’s aggregate exposure to such cash borrowing, short selling and specified derivatives transactions will not exceed 300% of its net asset value.
- As part of its investment strategies, each Fund will enter into specified derivatives transactions, borrow cash and/or sell short securities, provided that, in the case of a Fund that is not an Alternative Fund, these transactions do not result in any leverage in the portfolio of such Fund except to the extent permitted by NI 81-102 and, in the case of a Fund that is an Alternative Fund and in accordance with section 2.9.1 of NI 81-102, that Fund’s aggregate exposure to such cash borrowing, short selling and specified derivatives transactions will not exceed 300% of its net asset value.
- In connection with, among other things, the short sale of securities that the Funds will or may engage in, each Fund is permitted to grant a security interest in favour of, and deposit pledged portfolio assets with, its Prime Broker. If a Fund engages as its Prime Broker an entity that is not its custodian or sub-custodian, then a Fund that is not an Alternative Fund may, under section 6.8.1 of NI 81-102, only deliver to its Prime Broker portfolio assets having a market value, in the aggregate, of not more than 10% of the net asset value of the Fund at the time of deposit, and an Alternative Fund may, under section 6.8.1 of NI 81-102, only deliver to its Prime Broker portfolio assets having a market value, in the aggregate, of not more than 25% of the net asset value of the Alternative Fund at the time of deposit.
- A Prime Broker may not wish to act as borrowing agent for a Fund that is not an Alternative Fund and that wants to sell short securities having an aggregate market value of up to 10% of the Fund’s net asset value if the Prime Broker is only permitted to hold, as security for such transactions, portfolio assets, including the proceeds from the short sale, having an aggregate market value that is not in excess of 10% of the net asset value of the Fund. The issue is even greater in the context of an Alternative Fund, as a Prime Broker will not act as borrowing agent for an Alternative Fund that wants to sell short securities having an aggregate market value of up to 50% of the Alternative Fund’s net asset value if the Prime Broker is only permitted to hold, as security for such transactions, portfolio assets, including the proceeds from the short sale, having an aggregate market value that is not in excess of 25% of the net asset value of the Alternative Fund.
- Effective as of January 3, 2019, NI 81-102 was amended to include alternative mutual funds. Prior to and since that date, a number of investment fund managers have either launched alternative mutual funds or are planning to do so. The ability of alternative mutual funds to borrow cash and to sell short securities more extensively than other investment funds governed by NI 81-102 has led to the increased involvement of Prime Brokers in the operations of these alternative mutual funds. While the prime brokerage business model works well in the exempt investment fund space, the prime brokerage community and investment fund managers are experiencing greater difficulties in applying that model to alternative mutual funds and other investment funds under NI 81-102.
- The prime brokerage operational and pricing models in the context of short selling are premised on the ability of the Prime Broker to retain, as collateral for the obligations of the applicable Fund, the proceeds from the sale of the short sales, whether such proceeds are cash or are used by the Fund to purchase other portfolio assets. These models are also based on the ability of the Prime Broker to hold additional assets of the Fund as collateral for those obligations.
- Given the collateral requirements that Prime Brokers impose on their customers that engage in the short sale of securities, if the 10% and 25% of net asset value limitations set out in subsection 6.8.1 of NI 81-102 apply, then the Funds will need to retain two, or possibly three, Prime Brokers in order to sell short securities to the extent permitted under section 2.6.1 of NI 81-102. This would result in inefficiencies for the Funds and would increase their costs of operations. Alternatively, in order to address this issue, different methodologies have been adopted in connection with the calculation of the 10% and the 25% of net asset value limitations.
- While the collateral limits for the short sale of securities is currently topical in the context of alternative mutual funds, there is no policy reason to differentiate between the Alternative Funds and the Funds that are not Alternative Funds to the extent that these other Funds also engage in the short selling of securities.
- In addition, given the investment strategies described in paragraphs 9 and 10 above, the Filer also applied for relief from the requirements of subsection 6.8(4) of NI 81-102 in order to permit each Alternative Fund to allow its lender, in accordance with industry practice, to rehypothecate, including lending, pledging, transferring and/or selling, the portfolio assets of the Alternative Fund deposited with that lender pursuant to subsection 6.8(3.1) of NI 81-102. After discussions with OSC staff, the Filer withdrew its request for such relief based on the representations to it from OSC staff that (a) notwithstanding statements previously made in the Investment Funds Practitioner issued by the Investment Funds and Structured Products Branch of the OSC, nothing in section 6.8 of NI 81-102, including subsections 6.8(3), 6.8(3.1) and 6.8(4), precludes a Fund, including an Alternative Fund, from permitting the portfolio assets deposited by it pursuant to any of the subsections of section 6.8 of NI 81-102 to be rehypothecated and (b) the use of the term “beneficial owner” in subsection 6.8(4) of NI 81-102 is meant to refer to the right of the investment fund to have returned to it portfolio assets of the same issue as the deposited assets, including the same class or series, if applicable, and having the current aggregate market value of the deposited assets at the time of such return.
- It would not be prejudicial to the public interest to grant the Requested Relief to the Funds.
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator under the Legislation is that the Requested Relief is granted, provided that the Funds otherwise comply with subsections 6.8.1(2) and (3) of NI 81-102.
Investment Funds and Structured Products Branch
Ontario Securities Commission