Ontario Securities Commission
Headnote National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions - Relief granted to a commodity pool from paragraph 2.5(2)(a) and (c) of National Instrument 81-102 Mutual Funds to permit a commodity pool to gain exposure to another commodity pool implementing a two tiered structure, subject to certain conditions – Relief granted to the underlying commodity pools the same short selling exemption granted to the top funds.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, paragraphs 2.5(2)(a) and (c), section 2.6(a), (c) and 6.1(1) and section 19.1.
September 22, 2011
In the Matter of the Securities Legislation of Ontario
And
In the Matter of the Process for Exemptive Relief Applications in Multiple Jurisdictions
And
Friedberg Mercantile Group Ltd. and Toronto Trust Management Ltd.
(the Filers)
DECISION
Background
The securities regulatory authority or regulator in Ontario has received an application from the Filers for a decision under the securities legislation of the jurisdiction of the principal regulator (the Principal Regulator Legislation) for
(i) exemptive relief (the Fund on Fund Relief) from sections 2.1, 2.2 and paragraphs 2.5(2)(a) and (c) of National Instrument 81-102 Mutual Funds (NI 81-102) in respect of each of Friedberg Global-Macro Hedge Fund and Friedberg Asset Allocation Fund (the Existing Funds) and
(ii) exemptive relief (the Fund LP Relief) from sections 2.6(a), 2.6(c) and 6.1(1) of NI 81-102 in respect of each of Friedberg Global-Macro Hedge Fund LP (the Global LP) and Friedberg Asset Allocation Fund LP (the Asset Allocation LP, collectively, the Fund LPs).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(i) the Ontario Securities Commission is the principal regulator (the Principal Regulator) for this application; and
(ii) the Filers have provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of British Columbia, Alberta, Saskatchewan, Manitoba, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador, Yukon, Northwest Territories and Nunavut (collectively with Ontario, the Jurisdictions).
Interpretation
Terms defined in MI 11-102 and National Instrument 14-101 Definitions have the same meaning if used in this decision, unless otherwise defined.
Representations
This decision is based on the following facts severally represented by the Filers:
Background
Friedberg Mercantile Group Ltd. (FMGL) is a corporation that is existing under the Canada Business Corporations Act and Toronto Trust Management Ltd. (TTML) is a corporation that is existing under the Business Corporations Act (Ontario). TTML is a subsidiary of FMGL
FMGL is registered as an investment dealer in each of the provinces and territories of Canada. FMGL is a member of the Investment Industry Regulatory Organization of Canada (IIROC).
TTML has carried on (and continues to carry on) the activities of an investment fund manager, and has applied for registration as such under NI 31-103.
Each of the Existing Funds:
(a) is an investment trust established under the laws of the Province of Ontario pursuant to a declaration of trust;
(b) is a commodity pool (as such term is defined in section 1.1 of National Instrument 81-104 Commodity Pools (NI 81-104)), in that each Existing Fund has adopted fundamental investment objectives that permit it to gain exposure to or use or invest in specified derivatives in a manner that is not permitted under NI 81-102;
(c) has TTML as its trustee and manager, and has FMGL as its portfolio manager;
(d) offers its trust units to the public by long form prospectus in each of the Jursidictions; and
(e) is therefore subject to NI 81-102, NI 81-104, National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106), and other national instruments and securities legislation and policies applicable in the Jurisdictions.
- Each Existing Fund is a multi-strategy commodity pool whose investment objective is to seek significant total investment returns, consisting of a combination of interest income, currency gains and capital appreciation by investing in discrete groups of investments. Investment strategies of each of the Existing Funds include investing in long and short positions in securities and investing in long and short positions in currency and commodity derivatives instruments. In such regard, each of the Existing Funds has been granted exemptions dated July 10, 2008 and May 13, 2009 respectively from the applicable provisions of NI 81-102 to permit them to engage in limited short selling of securities, the representation and conditions for which are set out below (the Existing Short Selling Exemptions):
(a) each short sale made by an Existing Fund is subject to compliance with the investment objective of the Existing Fund;
(b) in order to effect short sales of securities, the Existing Fund borrows securities from either its custodian or a dealer (in either case, the Borrowing Agent), which Borrowing Agent may be acting either as principal for its own account or as agent for other lenders of securities;
(c) the Existing Fund has implemented the following controls when conducting short sales of securities:
(i) securities are sold short for cash, with the Existing Fund assuming the obligation to return to the Borrowing Agent the securities borrowed to effect the short sale;
(ii) the short sales are effected through market facilities through which the securities sold short are normally bought and sold;
(iii) the Existing Fund receives cash for securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(iv) the securities sold short are liquid securities that:
A. are listed and posted for trading on a stock exchange, and
the issuer of the security has a market capitalization of not less than CDN$300 million, or the equivalent thereof, of such security at the time the short sale is effected; or
the investment advisor has pre-arranged to borrow for the purposes of such short sale; or
B. are bonds, debentures or other evidences of indebtedness of or guaranteed by the Government of Canada or any province or territory of Canada or the Government of the United States of America;
(v) at the time securities of a particular issuer are sold short:
A. the aggregate market value of all securities of that issuer sold short by the Existing Fund do not exceed 2% of the net assets of the Existing Fund; and
B. the Existing Fund places a “stop-loss” order with a dealer to immediately purchase for the Existing Fund an equal number of the same securities if the trading price of the securities exceeds 120% (or such lesser percentage as the manager of the Existing Fund may determine) of the price at which the securities were sold short;
(vi) the Existing Fund deposits assets with the Borrowing Agent as security in connection with the short sale transaction;
(vii) the Existing Fund keeps proper books and records of all short sales and assets deposited with Borrowing Agents as security;
(viii) the Existing Fund has written policies and procedures for the conduct of short sales;
(ix) the Existing Fund provides disclosure in its prospectus as to: (A) short selling, (B) how the Existing Fund engages in short selling, (C) the risks associated with short selling; and (D) in the investment strategy section of the prospectus, the Existing Fund’s strategy and the Existing Short Selling Exemptions;
(x) the Existing Fund provides disclosure in its prospectus of the following information:
A. that there are written policies and procedures in place that set out the objectives and goals for short selling and the risk management procedures applicable to short selling;
B. who is responsible for setting and reviewing the policies and procedures referred to in the preceding paragraph, how often the policies and procedures are reviewed, and the extent and nature of the involvement of the board of directors or trustee in the risk management process;
C. the trading limits and other controls on short selling and who is responsible for authorizing the trading and placing limits or other controls on the trading;
D. whether there are individuals or groups that monitor the risks independent of those who trade; and
E. whether risk measurement procedures or simulations are used to test the portfolio under stress conditions;
(d) the aggregate market value of all securities sold short by the Existing Fund does not exceed the Applicable Percentage of the net assets of the Existing Fund on a daily marked-to-market basis (with the Existing Percentage in respect of Friedberg Global-Macro Hedge Fund being 40% and in respect of Friedberg Asset Allocation Fund being 25%);
(e) the Existing Fund holds “cash cover” (as defined in NI 81-102) in an amount, including the assets deposited with Borrowing Agents as security in connection with short sale transactions, that is at least 150% of the aggregate market value of all securities sold short by the Existing Fund on a daily marked-to-market basis;
(f) no proceeds from short sales of securities by the Existing Fund are used by the Existing Fund to purchase long positions in securities other than cash cover;
(g) the Existing Fund maintains appropriate internal controls regarding its short sales, including written policies and procedures, risk management controls and proper books and records;
(h) for short sale transactions in Canada, every dealer that holds assets as security in connection with short sale transactions by the Existing Fund is a registered dealer in Canada and a member of a self-regulatory organization that is a participating member of the Canadian Investor Protection Fund;
(i) for short sale transactions outside of Canada, every dealer that holds assets as security in connection with short sale transactions by the Existing Fund:
(i) is a member of a stock exchange and, as a result, be subject to a regulatory audit; and
(ii) has a net worth in excess of the equivalent of CDN$50 million determined from its most recent audited financial statements that have been made public;
(j) except where the Borrowing Agent is the Existing Fund’s custodian or a sub-custodian thereof, when the Existing Fund deposits assets with a Borrowing Agent as security in connection with a short sale transaction, the amount of assets deposited with the Borrowing Agent does not, when aggregated with the amount of assets already held by the Borrowing Agent as security for outstanding short sale transactions of the Existing Fund, exceed 10% of the net assets of the Existing Fund, taken at market value as at the time of the deposit; and
(k) the security interest provided by the Existing Fund over any of its assets that is required to enable the Existing Fund to effect short sale transactions is made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions.
Incentive Based Compensation
- The administrative and advisory fee structures for the Existing Funds consist of the following:
(a) management fees, calculated and payable monthly, at the annual rate of (i) 2% in respect of Friedberg Global-Macro Hedge Fund and (ii) 1% in respect of Friedberg Asset Allocation Fund; and
(b) incentive fees, calculated and payable quarterly, in respect of “net new profits” realized (subject to a “hurdle rate”). In respect of Friedberg Global-Macro Hedge Fund the incentive fee is 20% of net new profits, while in respect of Friedberg Asset Allocation Fund the incentive fee is 15% of net new profits.
As a result of the very strong past performance of the Existing Funds, significant incentive fees have been paid to FMGL in the past.
The introduction of the Harmonized Sales Tax (HST) as of July 1, 2010 has resulted in the sales taxes payable by the Existing Funds increasing almost three-fold (i.e. from the previous 5% Goods and Services Tax to the 13% HST). The incentive fees payable to FMGL would be subject to these increased taxes.
Unlike the vast majority of mutual funds governed by NI 81-102, the incentive fee structure for the Existing Funds (as is more customary for commodity pools) can result in far more significant indirect HST implications for the investors in the Existing Funds. As a result, FMGL and TTML sought the advice of tax advisors with respect to the possibility of reorganizing the Existing Funds in a manner which was fully compliant with all applicable federal and provincial tax legislation and could allow for significant potential savings for the Existing Funds (and, as a result, allow a greater portion of the net assets of the Existing Funds to be retained by them for the benefit of their respective unitholders).
Proposed Fund Restructurings
- The proposed restructuring of each Existing Fund will be implemented as follows:
(a) the Fund LPs have been established as limited partnerships;
(b) each Existing Fund will have its own separate Fund LP, dedicated solely to the investment activities of the subject Existing Fund;
(c) the sole general partner of each Fund LP is a new limited partnership established under the laws of Ontario under the name “Friedberg Advisors LP” (the Advisory LP). The sole general partner of the Advisory LP is Friedberg Advisors G.P. Inc., a wholly-owned subsidiary of FMGL, and the sole limited partner of the Advisory LP is TTML. The Advisory LP will be a registered portfolio manager under NI 31-103 (and, in this regard, it is intended that the individuals who are currently responsible for portfolio management for the Existing Funds at FMGL will be employed by the Advisory LP and, in such capacity, continue to be the individuals responsible for portfolio management for the Existing Funds at the Advisory LP, such that there will be no substantive change in the portfolio management arrangements for the Existing Funds from those currently in place);
(d) the portfolio investments (including derivatives positions) of the subject Existing Fund will be transferred, on a tax-deferred “rollover” basis, to its Fund LP in exchange for limited partnership units of the Fund LP, and with the subject Existing Fund to be and remain the sole limited partner of its Fund LP;
(e) TTML will continue to be the manager for each of the Existing Funds; and
(f) to replace the existing portfolio management agreement, including the entitlements of FMGL to earn incentive fees, the portfolio management services to be provided by the Advisory LP (as general partner of the Fund LP) will be provided for in the limited partnership agreement of the Fund LP, as will the entitlement of the Advisory LP to incentive fee distributions from the Fund LP. The incentive fee distribution entitlements will be calculated on the same basis as the existing incentive fee structure.
Unitholder approval for the proposed restructurings was sought and obtained at special meetings for each of the Existing Funds.
The aggregate amounts payable by an Existing Fund and its Fund LP will not change from the amounts that would be payable under the fee structures currently applicable to the Existing Fund, although it is currently contemplated that the administrative management fees (and HST thereon) will continue to be paid by the Existing Fund while the incentive fee distributions will be paid by its Fund LP to the Advisory LP under its entitlements under the limited partnership agreement of the Fund LP.
Going Forward Governance Arrangements
- The sole limited partner of a Fund LP will be its related Existing Fund, and:
(a) other than the limited partnership units of a Fund LP held by its Existing Fund, no securities of, or interest in, a Fund LP will be permitted to be issued to or held by any person or entity whatsoever other than the incentive distribution entitlements of the Advisory LP (which, as noted above, result in the identical amounts being payable from time to time by the Fund LP as would had been payable by the Existing Fund under the existing incentive fee arrangements);
(b) the limited partnership agreement of the Fund LP will provide that no change may be made in respect of the Fund LP which would have required the approval of its limited partner if the Fund LP were subject to NI 81-102 (including, without limitation, any change in its investment objectives) unless such approval of its limited partner (i.e. the Existing Fund) is obtained, and in such circumstances, the Existing Fund’s approval will be subject to the approval of its unitholders (i.e. appropriate “pass through” voting will be established);
(c) the investment objectives, strategies and restrictions otherwise applicable to the Existing Fund were it to have continued directly investing rather than indirectly investing through the Fund LP will in all respects apply to the Fund LP;
(d) in all respects, the Fund LP will be operated and governed in accordance with, and will be required to comply with, the provisions of NI 81-102, NI 81-104, NI 81-106 and applicable securities legislation in those Canadian jurisdictions in which the Existing Fund is a reporting issuer (such that, among other requirements, any requirements under Canadian securities legislation that would be applicable to incentive fees for the Existing Funds will be complied with in respect of incentive distributions payable by the Fund LPs to the Advisory LP);
(e) the Fund LP will be an open-ended mutual fund which permits contributions and withdrawals of its limited partnership interests on the identical basis as its Existing Fund; such that net subscriptions or net redemptions, as applicable, at the Existing Fund level will result in the identically proportionate net contributions or net withdrawals of limited partnership capital from the Fund LP; and
(f) with the exception of the “pass-through” of a redemption discount on the same basis as currently applies for the Existing Funds (with respect to each Existing Fund, the amount paid to a redeeming unitholder is the aggregate net asset value per unit of the units redeemed less 0.375%, which is retained by the Existing Fund and not by FMGL, TTML or any other person or entity), there will be no fees of any kind payable by an Existing Fund in respect of any contribution to, or withdrawal of, limited partnership capital from its Fund LP.
Going Forward Prospectus and Continuous Disclosure Obligations
As the holdings of limited partnership interests in its Fund LP will be the sole investment and undertaking of the subject Existing Fund, and the subject Existing Fund will be the sole securityholder of its Fund LP (other than the Advisory LP, as described above), it is contemplated that the long form prospectus of an Existing Fund will include full, true and plain disclosure not only of the Existing Fund but also of its Fund LP, such that potential investors in an Existing Fund can obtain all appropriate prospectus disclosure by reading the prospectus of the Existing Fund. In addition, each Fund LP will file a prospectus in Ontario thereby becoming a reporting issuer and being subject to the continuous disclosure obligations under NI 81-106. For the purposes of the going forward continuous disclosure obligations of the Existing Funds, any material change in respect of a Fund LP will be considered a material change for its Existing Fund.
FMGL and TTML have been advised by an accounting consultant engaged by them that the proposed arrangements as between an Existing Fund and its Fund LP as described in this decision are such that the financial results of a Fund LP should, under International Financial Reporting Standards, be consolidated into the financial statements of its Existing Fund. As a result, all financial reporting contemplated under NI 81-106 for the Existing Fund will have to reflect the consolidated financial results and position of the Existing Fund and its Fund LP. Further, this will result in any financial disclosure in the prospectus of an Existing Fund being the consolidated financial results of the Existing Fund and its Fund LP.
The disclosure documents of the Existing Funds will include:
(a) appropriate disclosure as to the tax ramifications, and potential risks, arising from the restructuring; and
(b) disclosure identifying the incentive distributions payable by the Fund LPs to the Advisory LP as “incentive fee distributions”, and treating and disclosing such distributions as part of the consolidated fees to which the Existing Funds are directly or indirectly subject (such that the incentive distributions will be included in the consolidated management expense ratio calculations of the Existing Funds).
Decision
The Principal Regulator is satisfied that the decision meets the test set out in the Legislation for the relevant regulator or securities regulatory authority to make the decision.
The decision of the Principal Regulator is that the Fund on Fund Relief is granted provided that:
(a) each Fund LP is a mutual fund that has offered securities under a prospectus in Ontario;
(b) other than the limited partnership units of a Fund LP held by its Existing Fund, no securities of, or interest in, a Fund LP will be permitted to be issued to or held by any person or entity whatsoever other than incentive fee distribution entitlements of the Advisory LP;
(c) the limited partnership agreement of the Fund LP will provide that no change may be made in respect of the Fund LP which would have required the approval of its limited partner if the Fund LP were subject to NI 81-102 (including, without limitation, any change in its investment objectives) unless such approval of its limited partner (i.e. the Existing Fund) is obtained and, In such circumstances, the Existing Fund’s approval will be subject to the approval of its unitholders (i.e. appropriate “pass through” voting will be established); and
(d) the investment objectives, strategies and restrictions otherwise applicable to the Existing Fund were it to have continued directly investing rather than indirectly investing through the Fund LP will in all respects apply to the Fund LP;
and the Fund LP Relief is granted to the Global LP provided that :
(a) the aggregate market value of all securities sold short by the Global LP and Friedberg Global-Macro Hedge Fund does not exceed 40% of the net assets of Friedberg Global-Macro Hedge Fund on a daily marked-to-market basis;
(b) the Global LP holds “cash cover” (as defined in NI 81‑102) in an amount, including fund deposited with Borrowing Agents as security in connection with short sale transactions, that is at least 150% of the aggregate market value of all securities sold short by the Global LP on a daily marked-to-market basis;
(c) no proceeds from short sales of securities by the Global LP are used by the fund to purchase long positions in securities other than cash cover;
(d) the Global LP maintains appropriate internal controls regarding its short sales, including written policies and procedures, risk management controls and proper books and records;
(e) any short sale made by the Global LP is subject to compliance with the investment objective of the Global LP;
(f) for short sale transactions in Canada, every dealer that holds fund assets as security in connection with short sale transactions by the Global LP shall be a registered dealer in Canada and a member of a self-regulatory organization that is a participating member of the Canadian Investor Protection Fund;
(g) for short sale transactions outside of Canada, every dealer that holds fund assets as security in connection with short sale transactions by the Global LP shall:
(i) be a member of a stock exchange and, as a result, be subject to a regulatory audit; and
(ii) have a net worth in excess of the equivalent of CDN$50 million determined from its most recent audited financial statements that have been made public;
(h) except where the Borrowing Agent is the Global LP’s custodian or a sub-custodian thereof, when the Global LP deposits fund assets with a Borrowing Agent as security in connection with a short sale transaction, the amount of fund assets deposited with the Borrowing Agent does not, when aggregated with the amount of Fund assets already held by the Borrowing Agent as security for outstanding short sale transactions of the Fund, exceed 10% of the net assets of the Global LP, taken at market value as at the time of the deposit;
(i) the security interest provided by the Global LP over any of its assets that is required to enable the Global LP to effect short sale transactions is made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions; and
(j) prior to conducting any short sales of securities, the Asset Allocation LP discloses in its prospectus the following information:
(i) that there are written policies and procedures in place that set out the objectives and goals for short selling and the risk management procedures applicable to short selling;
(ii) who is responsible for setting and reviewing the policies and procedures referred to in the preceding paragraph, how often the policies and procedures are reviewed, and the extent and nature of the involvement of the board of directors or trustee in the risk management process;
(iii) the trading limits and other controls on short selling and who is responsible for authorizing the trading and placing limits or other controls on the trading;
(iv) whether there are individuals or groups that monitor the risks independent of those who trade; and
(v) whether risk measurement procedures or simulations are used to test the portfolio under stress conditions;
and the Fund LP Relief is granted to the Asset Allocation LP provided
(a) the aggregate market value of all securities sold short by the Asset Allocation LP and Friedberg Asset Allocation Fund does not exceed 25% of the net assets of Friedberg Asset Allocation Fund on a daily marked-to-market basis;
(b) the Asset Allocation LP holds “cash cover” (as defined in NI 81‑102) in an amount, including the fund assets deposited with Borrowing Agents as security in connection with short sale transactions, that is at least 150% of the aggregate market value of all securities sold short by the fund on a daily marked-to-market basis;
(c) no proceeds from short sales of securities by the Asset Allocation LP are used by the fund to purchase long positions in securities other than cash cover;
(d) the Asset Allocation LP maintains appropriate internal controls regarding its short sales, including written policies and procedures, risk management controls and proper books and records;
(e) any short sale made by the Asset Allocation LP is subject to compliance with the investment objective of the Asset Allocation LP;
(f) for short sale transactions in Canada, every dealer that holds fund assets as security in connection with short sale transactions by the Fund shall be a registered dealer in Canada and a member of a self-regulatory organization that is a participating member of the Canadian Investor Protection Fund;
(g) for short sale transactions outside of Canada, every dealer that holds Fund assets as security in connection with short sale transactions by the Asset Allocation LP shall:
(i) be a member of a stock exchange and, as a result, be subject to a regulatory audit; and
(ii) have a net worth in excess of the equivalent of CDN$50 million determined from its most recent audited financial statements that have been made public;
(h) except where the Borrowing Agent is the Asset Allocation LP’s custodian or a sub-custodian thereof, when the Asset Allocation LP deposits Fund assets with a Borrowing Agent as security in connection with a short sale transaction, the amount of Fund assets deposited with the Borrowing Agent does not, when aggregated with the amount of Fund assets already held by the Borrowing Agent as security for outstanding short sale transactions of the Asset Allocation LP, exceed 10% of the net assets of the Asset Allocation LP, taken at market value as at the time of the deposit;
(i) the security interest provided by the Asset Allocation LP over any of its assets that is required to enable the Asset Allocation LP to effect short sale transactions is made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions; and
(j) prior to conducting any short sales of securities, the Asset Allocation LP discloses in its prospectus the following information:
(i) that there are written policies and procedures in place that set out the objectives and goals for short selling and the risk management procedures applicable to short selling;
(ii) who is responsible for setting and reviewing the policies and procedures referred to in the preceding paragraph, how often the policies and procedures are reviewed, and the extent and nature of the involvement of the board of directors or trustee in the risk management process;
(iii) the trading limits and other controls on short selling and who is responsible for authorizing the trading and placing limits or other controls on the trading;
(iv) whether there are individuals or groups that monitor the risks independent of those who trade; and
(v) whether risk measurement procedures or simulations are used to test the portfolio under stress conditions.
"Darren McKall"
Darren McKall
Manager, Investment Funds
Ontario Securities Commission