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Arrow Capital Management Inc. et al.
Headnote
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- Relief granted from requirement in National Instrument 81-102 Investment Funds to permit alternative mutual funds to short sell up to 100% of net asset value in connection with "market neutral" or other short selling strategies -- NI 81-102 would allow funds to achieve similar short exposure through derivatives -- Physical short selling is cheaper and more efficient and will not increase risk to the funds compared to short exposure through derivatives -- Relief also 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 -- Relief also granted from the single custodian requirement to permit the use of more than one custodian for securities lending purposes only -- Relief is required to appoint a securities lending agent that is not a custodian or sub-custodian of the funds -- Funds will have a single administrator that will reconcile all the portfolio assets of the funds and provide valuation services -- Other custodians will meet all the Part 6 requirements of NI 81-102 -- Other custodians will only act as custodian and securities lending agent for securities of the funds transferred to them.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6.1(1)(c)(v), 2.6.2, 6.1(1), 6.1, 6.8.1, 19.1.
May 29, 2020
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO (the Jurisdiction) AND IN THE MATTER OF THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS AND IN THE MATTER OF ARROW CAPITAL MANAGEMENT INC. (the Filer) AND EXEMPLAR GROWTH AND INCOME FUND, EXEMPLAR INVESTMENT GRADE FUND, EXEMPLAR PERFORMANCE FUND, ARROW CANADIAN ADVANTAGE ALTERNATIVE CLASS, ARROW GLOBAL ADVANTAGE ALTERNATIVE CLASS, EAST COAST INVESTMENT GRADE INCOME FUND (the Existing Funds)
DECISION
Background
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Existing Funds, of which the Filer is the investment fund manager, and similarly structured investment funds managed by the Filer (the Future Funds and together with the Existing Funds, the Funds or individually, a Fund), for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) that exempts:
1) a Fund that is an Alternative Fund (as defined below), in order to permit the Alternative Fund to short sell securities having an aggregate market value of up to 100% of the Alternative Fund's net asset value (NAV), from the following provisions (the Short Selling Restrictions)
a) subparagraph 2.6.1(1)(c)(v) of National Instrument 81-102 Investment Funds (NI 81-102), which restricts an alternative mutual fund from selling a security short if, at the time, the aggregate market value of the securities sold short by the Fund exceeds 50% of the Funds' NAV; and
b) section 2.6.2 of NI 81-102, which prohibits an alternative mutual fund from borrowing cash or selling securities short if, immediately after entering into a cash borrowing or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the fund would exceed 50% of the Fund's NAV;
(the Market-Neutral Strategy Relief);
2. a Fund from the requirement in subsection 6.1(1) of NI 81-102, which provides that, except as provided in sections 6.8, 6.8.1 and 6.9 of NI 81-102, all portfolio assets of an investment fund must be held under the custodianship of one custodian that satisfies the requirement of section 6.2 of NI 81-102, in order to permit a Fund to deposit portfolio assets with a borrowing agent that is not the Fund's custodian or sub-custodian in connection with a short sale of securities, if the aggregate market value of the 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, does not:
a) in the case of a Conventional Fund (as defined below) exceed 10% of NAV of the Conventional Fund at the time of deposit; and
b) in the case of an Alternative Fund, exceed 25% of the NAV of the Alternative Fund at the time of deposit;
(the Short Sale Collateral Relief); and
3. a Fund from the requirement in subsection 6.1(1) of NI 81-102 solely to permit the Fund to appoint more than one custodian, each of which is qualified to be a custodian under section 6.2 of NI 81-102 and each of which is subject to all of the other requirements in Part 6 of NI 81-102 other than the prohibition against the Fund appointing more than one custodian in subsection 6.1(1) of NI 81-102
(the Custodian Relief, and collectively with the Market-Neutral Strategy Relief and the Short Sale Collateral Relief, the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada (collectively, the Other Jurisdictions) (together with the Jurisdiction, the Canadian Jurisdictions).
Interpretation
Terms defined in NI 81-102, National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
AIF means an annual information from of a Fund prepared in accordance with Form 81-102 F2 -- Contents of Annual Information Form under National Instrument 81-101 Mutual Fund Prospectus Disclosure (NI 81-101), as the same may be amended from time to time;
Alternative Fund means a Fund that is an alternative mutual fund under NI 81-102;
Conventional Fund means a Fund that is not an alternative mutual fund under NI 81-102;
Prime Broker means any entity that acts as a lender or borrowing agent, as the case may be, to one or more investment funds, whether the investment fund is an alternative mutual fund or a mutual fund;
Prospectus means a simplified prospectus of a Fund prepared in accordance with Form 81-101 F1 -- Contents of Simplified Prospectus under NI 81-101 as the same may be amended from time to time;
Securities Lending Agreements means agreements which effect securities lending, repurchase or reverse repurchase transactions between a Fund, as lender of the securities, third party borrowers and the Fund's securities lending agent; and
Short Sale Collateral Limits means the limits specified in subparagraph 6.8.1(1)(a) (for Conventional Funds) and subparagraph 6.8.1(1)(b) (for Alternative Funds) of NI 81-102 on the deposit of portfolio assets by a Fund with a borrowing agent (that is not the custodian or a sub-custodian of the Fund) as security in connection with a short sale of securities.
Representations
This decision is based on the following facts represented by the Filer on behalf of itself and the Funds:
The Filer
1. The Filer is a corporation existing under the laws of Ontario having its registered head office in Toronto, Ontario.
2. The Filer is the investment fund manager and portfolio manager of each Existing Fund. The Filer, or an affiliate, will be the investment fund manager and portfolio manager of the Future Funds.
3. The Filer is registered in the following categories in the jurisdictions as indicated below:
(a) Ontario: Portfolio Manager (PM), Investment Fund Manager (IFM); Exempt Market Dealer (EMD) and Commodity Trading Manager under the Commodity Futures Act (Ontario);
(b) Alberta: EMD;
(c) British Columbia: EMD;
(d) Quebec: EMD and IFM; and
(e) Newfoundland and Labrador: IFM.
4. The Filer is not in default of securities legislation in any of the Canadian Jurisdictions.
The Funds
5. The Funds are or will be open-ended public Alternative Funds or Conventional Funds governed by NI 81-102.
6. The Funds are or will be organized as trusts or as part of a mutual fund corporation established under the laws of the Province of Ontario.
7. The Funds will distribute securities in each of the Canadian Jurisdictions pursuant to a simplified prospectus, annual information form and fund facts documents, prepared and filed in accordance with NI 81-101 and, accordingly, each Fund is, or will be, a reporting issuer in the Canadian Jurisdictions where the Exemption Sought is relied upon.
8. The Funds are not in default of applicable securities legislation in any of the Canadian Jurisdictions.
9. In a notice of special meeting and management information circular mailed to unitholders of the East Coast Investment Grade Income Fund (the East Coast Fund) dated May 13, 2020, the Filer proposed to unitholders of the East Coast Fund to restructure the East Coast Fund by converting it to an open-end alternative mutual fund from a closed-end investment fund whose units are listed for trading on the Toronto Stock Exchange (the TSX) under the symbol ECF.UN (the Restructuring). It is expected that unitholders will approve the Restructuring at a special meeting of unitholders to be held on June 12, 2020. As part of the Restructuring the name of the East Coast Fund will be changed to Arrow EC Income Advantage Alternative Fund from East Coast Investment Grade Income Fund. It is expected that the units will be de-listed from the TSX as part of the Restructuring.
10. The East Coast Fund is filing a simplified prospectus, annual information form and fund facts documents such that the East Coast Fund will become an alternative mutual fund to which NI 81-102 applies in that the East Coast Fund has fundamental investment objectives that permits it to borrow, sell securities short and invest in specified derivatives in a manner not permitted for non-alternative mutual funds under NI 81-102.
Reasons for the Exemption Sought
Market-Neutral Strategy Relief
11. The investment strategies of each Alternative Fund will permit the Alternative Fund to borrow cash, enter into specified derivatives transactions or sell securities short, provided that immediately after entering into a cash borrowing, specified derivative or short selling transaction, the aggregate value of cash borrowed combined with the aggregate market value of securities sold short by the Alternative Fund and aggregate notional amount of the Alternative Fund's specified derivatives positions, minus the aggregate notional amount of the specified derivative positions that are hedging transactions, would not exceed 300% of the NAV of the Alternative Fund (the Leverage Limit). If the Leverage Limit is exceeded, the Alternative Fund shall, as quickly as is commercially reasonable, take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short and the aggregate notional amount of the Alternative Fund's specified derivatives positions, minus the aggregate notional amount of the specified derivative positions that are hedging transactions, to be within the Leverage Limit, in compliance with section 2.9.1 of NI 81-102.
12. A key investment strategy to be utilized by each of the Alternative Funds includes the use of market-neutral, offsetting, inverse or shorting strategies (Market-Neutral Strategies) requiring the use of short selling in excess of 50% of the NAV of the Alternative Fund.
13. Market-Neutral Strategies are well-recognized for limiting market risk by balancing long and short positions within an investment portfolio with the objective of providing positive returns regardless of whether the broader market rises, falls or is flat. Market-Neutral Strategies are designed to have less volatility than the broader market when measured over medium to long term periods. Market-Neutral Strategies also provide diversification to investors as returns are intended to be uncorrelated to the performance of the broader market -- such strategies are designed to effectively remove any "beta" component from their returns and investment exposures.
14. Market-Neutral Strategies include strategies which offset exposure to certain markets or provide inverse exposure to particular sets of securities would also fall within the investment strategies of the Alternative Funds and serve to reduce market risk or keep market risk at a specified level or deliver a specific investment risk-return profile that investors and their advisors can utilize for the purposes of portfolio diversification.
15. In a Market-Neutral Strategy, short positions can serve as both a hedge against exposure to a long position, or group of long positions, and also as a source of returns with an offsetting long position or positions. The objective of Market-Neutral Strategies is to generate an attractive risk/return profile independent of the direction of broad equity markets.
16. The Alternative Funds require the flexibility to enter into physical short positions in order to implement Market-Neutral Strategies, when doing so is, in the opinion of the Filer, in the best interests of the Alternative Funds.
17. The Filer is an experienced investment fund manager and engages, or will engage, experienced portfolio managers that have an ability to effectively utilize Market-Neutral Strategies on behalf of their clients.
18. In addition, while there may be certain situations in which using a synthetic short position may be preferable, physical shorts are typically less costly, because of the ability to execute trades with a larger number of counterparties, compared to a single counterparty for synthetic shorts. This can result in wider options for borrowing securities resulting in lower borrowing costs. Alternative Funds may also be exposed to less counterparty risk than with a synthetic short position (e.g. counterparty default, counterparty insolvency and premature termination of derivatives).
19. Any physical short position entered into by an Alternative Fund will be consistent with the investment objectives and strategies of the applicable Alternative Fund.
20. The investment strategies of each Alternative Fund permit, or will permit, it to sell securities short provided that, at the time the Alternative Fund sells a security short (i) the aggregate market value of securities of any one issuer (other than "government securities" as defined in NI 81-102) sold short by the Alternative Fund does not exceed 10% of the NAV of the Alternative Fund and (ii) the aggregate market value of all securities sold short by the Alternative Fund does not exceed 100% of its NAV.
21. The investment strategies of each Alternative Fund permit, or will permit, it to enter into a cash borrowing (to a maximum of 50% of the Alternative Fund's NAV) or short selling transaction, provided that the aggregate value of cash borrowed combined with the aggregate market value of the securities sold short by the Alternative Fund does not exceed 100% of the Alternative Fund's NAV (the Total Borrowing and Short Sales Limit). If the Total Borrowing and Short Sales Limit is exceeded, the Alternative Fund shall, as quickly as is commercially reasonable, take all necessary steps to reduce the aggregate value of cash borrowed combined with the aggregate market value of securities sold short to be within the Total Borrowing and Short Sales Limit.
22. While the Filer could achieve the desired short position using specified derivatives under NI 81-102, it is requesting the Market-Neutral Strategy Relief in order to have the flexibility to use physical short selling to achieve the desired short exposure as appropriate, rather than being required to use synthetic means to achieve the Market Neutral Strategies. The Market-Neutral Strategy Relief will provide the Filer, on behalf of the Alternative Funds, with the necessary flexibility to make timely trading decisions between physical short and synthetic short positions based on what is in the best interests of the Alternative Funds. The Filer, as registrant and fiduciary, is in the best position to determine whether an Alternative Fund should enter into a physical short position or a synthetic short position, depending on the relevant circumstances. The Filer has requested the Market-Neutral Relief in order to permit the Filer to engage in the most effective portfolio management available for the benefit of the Alternative Funds and their securityholders.
23. The Prospectus, AIF and fund facts documents will comply with the requirements of NI 81-101 applicable to alternative mutual funds, including cover page text box disclosure in the fund facts documents to highlight how the Alternative Fund differs from other mutual funds and emphasize that short selling strategies permitted by the Alternative Fund are outside the scope of NI 81-102 applicable to both mutual funds and alternative mutual funds.
24. The investment strategies of each Alternative Fund will clearly disclose that short selling strategies of the Alternative Fund which are outside the scope of NI 81-102, including that the aggregate market value of all securities sold short by the Alternative Fund may exceed 50% of the NAV of the Alternative Fund. The Prospectus will also contain appropriate risk disclosure, alerting investors of any material risks associated with such investment strategies.
25. The Filer will determine the risk rating for each Alternative Fund using the Investment Risk Classification Methodology as set out in Appendix F of NI 81-102.
26. The Filer has comprehensive risk management policies and procedures that address the risks associated with short selling in connection with the utilization of a market-neutral strategy.
27. Each Alternative Fund will implement the following controls when conducting a short sale:
(a) the Alternative Fund will assume the obligation to return to the Borrowing Agent (as defined in NI 81-102) the securities borrowed to effect the short sale;
(b) the Alternative Fund will receive cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer will monitor the short positions of the Alternative Fund at least as frequently as daily;
(d) the security interest provided by the Alternative Fund over any of its assets that is required to enable the Alternative Fund to effect a short sale transaction is made in accordance with section 6.8.1 of NI 81-102 and will otherwise be in accordance industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Filer will maintain appropriate internal controls regarding short sales, including written policies and procedures for the conduct of short sales, risk management controls and proper books and records; and
(f) the Filer and the Alternative Fund will keep proper books and records of short sales and all of its assets deposited with Borrowing Agents as security.
28. The Filer believes that it is in the best interests of each of the Alternative Funds to be permitted to engage in physical short selling in excess of the current limits set out in NI 81-102 applicable to alternative mutual funds.
Short Sale Collateral Relief
29. As part of its investment strategies, each Fund that engages in short sales of securities is permitted to grant a security interest in favour of and to 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 Conventional Fund may only deliver to its Prime Broker portfolio assets having a market value, in the aggregate, of not more than 10% of the NAV of the Conventional Fund at the time of deposit and an Alternative Fund may only deliver to its Prime Broker portfolio assets having a market value, in the aggregate, of not more than 25% of the NAV of the Alternative Fund at the time of deposit.
30. A Prime Broker may not wish to act as the borrowing agent for a Conventional Fund that wants to short sell securities having an aggregate market value of up to 10% of the Conventional Fund's NAV if the Prime Broker is only permitted to hold, as security for such transactions, portfolio assets having and aggregate market value that is not in excess of 10% of the NAV of the Conventional Fund. This issue is even greater in the context of an Alternative Fund as a counterparty may not act as the Prime Broker for an Alternative Fund that wants to sell securities short that have an aggregate market value of up to 50% of the Alternative Fund's NAV (or more if the Market-Neutral Strategy Relief is granted) if the Prime Broker is only permitted to hold, as security for such transactions, portfolio assets having an aggregate market value that is not in excess of 25% of the NAV of the Alternative Fund.
31. As a result of the Short Sale Collateral Limits, the Funds are required to engage numerous Prime Brokers in order to fully utilize the ability of the Funds to engage in short selling of securities. Managing and overseeing relationships with multiple Prime Brokers introduces unnecessary operational and administrative complexities and additional potential costs to a Fund.
32. Prime Brokers that are qualified to act as a custodian or sub-custodian under NI 81-102 are not widely appointed as custodians or sub-custodians under NI 81-102 as it can be both operationally challenging and costly to appoint them to act in such capacity.
33. Given the typical collateral requirements that Prime Brokers impose on their customers who engage in the short sale of securities, if the Short Sale Collateral Limits apply, the Funds would need to retain multiple Prime Brokers in order to sell short securities to the extent permitted under section 2.6.1 of NI 81-102 and, if granted, the Market-Neutral Strategy Relief described above. This would result in inefficiencies for the Funds and would increase their costs of operations.
34. The Filer does not believe that there should be any policy reason to differentiate between its Alternative Funds and its Conventional Funds to the extent that these Funds also engage in the short selling of securities.
Custodian Relief
35. The Filer would like the flexibility for each Fund to engage Prime Brokers as additional custodians provided that such Prime Brokers are qualified to act as a custodian under section 6.2 of NI 81-102 (each, an Additional Custodian). The Filer and any Additional Custodians would be subject to all requirements applicable to custodians under Part 6 of NI 81-102, other than the requirement in subsection 6.1(1) of NI 81-102 that there only be one custodian. The Filer has requested the Custodian Relief in order to provide additional flexibility for the Funds to engage in the short selling of securities under section 6.8.1 of NI 81-102, as portfolio assets deposited with a borrowing agent that is the custodian or a sub-custodian of the Fund are not subject to the 10% and 25% of NAV limitations in subparagraph 6.8.1(1)(a) and 6.8.1(1)(b), respectively.
36. An Additional Custodian may also be appointed as a securities lending agent of the Funds and, in such circumstances, would provide the Funds with the opportunity to enter into a greater number of Securities Lending Agreements than would be the case with a single custodian and would therefore have the potential to increase revenues to the Funds from securities lending activities.
37. Prime Brokers are not widely appointed as sub-custodians by custodians under NI 81-102 as it can be both operationally challenging for the custodian and the Filer to appoint them to act in such capacity. This is especially true in circumstances where the custodian of a Fund is a Prime Broker.
38. If the Custodian Relief is granted, an Additional Custodian's responsibility for custody of the Funds' assets will apply only to the assets held by the Additional Custodian on behalf of the Funds (the Relevant Assets). The custodial arrangements between the Funds and each Additional Custodian will comply with the requirements of Part 6 of NI 81-102 other than subsection 6.1(1).
39. The appointment of an Additional Custodian as a securities lending agent by the Funds would provide the Funds with the opportunity to participate in a greater number of Securities Lending Agreements than would be the case with a single custodian and would therefore have the potential to increase revenues to the Funds from securities lending activities.
40. Any Additional Custodian will meet the requirements of NI 81-102 to act as a custodian for an investment fund and will have experience acting as custodian of the assets of public investment funds governed by NI 81-102. As custodian of the Relevant Assets, an Additional Custodian will comply with the standard of care applicable to qualified custodians under section 6.6 of NI 81-102, will hold the Relevant Assets in the name of the applicable Fund in accordance with section 6.5 of NI 81-102 and will include the provisions prescribed in section 6.4 of NI 81-102 in its custody agreement with the Filer and the Funds. Each Additional Custodian will complete the review and provide compliance reports to the Filer as contemplated in section 6.7 of NI 81-102.
41. The ability to terminate an Additional Custodian as custodian of the Relevant Assets of a Fund at any time without cause on written notice will ensure that the Filer maintains ultimate control over all of the portfolio assets of the Funds and can restore all assets to the custody of the Custodian at any time if the Filer considers it to be in the best interests of the Funds and their respective securityholders to do so.
42. The appointment of an Additional Custodian should have no impact on the safety of the portfolio assets of the Funds while enhancing the Fund's abilities to engage in the short selling of securities under section 6.8.1 of NI 81-102 and to enter into additional Securities Lending Agreements.
43. Upon receipt of the Custodian Relief and appointment of an Additional Custodian, the Filer will provide notice of the appointment of any Additional Custodian to securityholders and amend the Prospectus and AIF of the applicable Funds to include disclosure regarding the Custodial Relief and particulars of the appointment of an Additional Custodian of the Funds with respect to the Relevant Assets.
Decision
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 Exemption Sought is granted provided that:
In respect of the Market-Neutral Strategy Relief:
1. An Alternative Fund may sell a security short or borrow cash only if, immediately after the cash borrowing or short selling transaction:
(a) the aggregate market value of all securities sold short by the Alternative Fund does not exceed 100% of the Alternative Fund's NAV;
(b) the aggregate value of cash borrowing by the Alternative Fund does not exceed 50% of the Alternative Fund's NAV;
(c) the aggregate market value of securities sold short by the Alternative Fund combined with the aggregate value of cash borrowing by the Alternative Fund does not exceed 100% of the Alternative Fund's NAV; and
(d) the Alternative Fund's aggregate exposure to short selling, cash borrowing and specified derivatives does not exceed the Leverage Limit.
2. In the case of a short sale, the short sale:
(a) otherwise complies with all of the short sale requirements applicable to alternative mutual funds under section 2.6.1 and 2.6.2 of NI 81-102; and
(b) is consistent with the Alternative Fund's investment objectives and strategies.
3. The Prospectus under which units of an Alternative Fund are offered:
(a) discloses that the Alternative Fund can short sell securities having an aggregate market value of up to 100% of the Alternative Fund's NAV; and
(b) describes the material terms of this decision.
In respect of the Short Sale Collateral Relief:
4. Each Fund otherwise complies with subsections 6.8.1(2) and (3) of NI 81-102.
In respect of the Custodian Relief:
5. A Fund may appoint one or more Additional Custodians if:
(a) a single entity reconciles all the portfolio assets of the Fund and provides the Fund with valuation and securityholder recordkeeping services and will complete daily reconciliations amongst the custodians before striking a daily NAV;
(b) the Filer maintains such operational systems and processes, as between two or more custodians and the single entity referred to in clause 5(a), in order to keep a proper reconciliation of all the portfolio assets that will move amongst the custodians, as appropriate; and
(c) Each Additional Custodian will act as custodian and securities lending agent only for the portion of portfolio assets of the Fund transferred to it.
"Darren McKall"
Investment Funds & Structured Products Branch
Ontario Securities Commission