Headnote
National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – relief from certain specified derivatives and custodial requirements to permit mutual funds to enter into swap transactions that are cleared through a clearing corporation – relief required because of new U.S. requirements to clear over-the-counter derivatives including swaps - decision treats cleared swaps similar to other cleared derivatives – National Instrument 81-102 Mutual Funds
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1) and (4), 6.8(1), 19.1
December 17, 2013
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 BRANDES INVESTMENT PARTNERS & CO. (the Filer)
DECISION
Background
The principal regulator in the Jurisdiction has received an application from the Filer for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation), pursuant to section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102), exempting each Existing Bridgehouse Fund (as defined below) and all current and future mutual funds managed by the Filer that enter into Swaps (as defined below) in the future (each, a Future Bridgehouse Fund and, together with the Existing Bridgehouse Funds, each, a Bridgehouse Fund and, collectively, the Bridgehouse Funds):
(i) from the requirement in subsection 2.7(1) of NI 81-102 that a mutual fund must not purchase an option or a debt-like security or enter into a swap or a forward contract unless, at the time of the transaction, the option, debt-like security, swap or contract has a designated rating or the equivalent debt of the counterparty, or of a person or company that has fully and unconditionally guaranteed the obligations of the counterparty in respect of the option, debt-like security, swap or contract, has a designated rating;
(ii) from the limitation in subsection 2.7(4) of NI 81-102 that the mark-to-market value of the exposure of a mutual fund under its specified derivatives positions with any one counterparty other than an acceptable clearing corporation or a clearing corporation that settles transactions made on a futures exchange listed in Appendix A to NI 81-102 shall not exceed, for a period of 30 days or more, 10 percent of the net asset value of the mutual fund; and
(iii) from the requirement in subsection 6.1(1) of NI 81-102 to hold all portfolio assets of a mutual fund under the custodianship of one custodian in order to permit each Bridgehouse Fund to deposit cash and other portfolio assets directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) as margin,
in each case, with respect to cleared Swaps (the Requested Relief).
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 (the Other Jurisdictions, and 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. Capitalized terms used in this decision have the following meanings:
“CFTC” means the U.S. Commodity Futures Trading Commission
“Clearing Corporation” means any of the Chicago Mercantile Exchange Inc., ICE Clear Credit LLC, LCH.Clearnet Limited and any other clearing organization that is permitted to operate in the Canadian Jurisdiction where the Bridgehouse Fund is located
“Dodd-Frank” means the Dodd-Frank Wall Street Reform and Consumer Protection Act
“Existing Bridgehouse Funds” means Lazard Emerging Markets Multi-Strategy Fund and Lazard Global Equity Income Fund
“Futures Commission Merchant” means any futures commission merchant that is registered with the CFTC and is a member of a Clearing Corporation
“OTC” means over-the-counter
“Portfolio Advisor” means each of the Filer and each affiliate of the Filer and each third party portfolio manager retained from time to time by the Filer as portfolio sub-advisor to manage all or a portion of the investment portfolio of one or more Bridgehouse Funds
“Swaps” means the swaps that are, or will become, subject to a clearing determination issued by the CFTC, including fixed-to-floating interest rate swaps, basis swaps, forward rate agreements in U.S. dollars, the Euro, Pounds Sterling or the Japanese Yen, overnight index swaps in U.S. dollars, the Euro and Pounds Sterling and untranched credit default swaps on certain North American indices (CDX.NA.IG and CDX.NA.HY) and European indices (iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe HiVol) at various tenors
“U.S. Person” has the meaning attributed thereto by the CFTC
Representations
This decision is based on the following facts represented by the Filer:
The Filer is, or will be, the investment fund manager of each Bridgehouse Fund. The Filer is registered as an investment fund manager, a portfolio manager, an exempt market dealer and a mutual fund dealer in the Jurisdiction. The Filer is also registered as a portfolio manager and an exempt market dealer in all of the Other Jurisdictions, as a mutual fund dealer in all of the Other Jurisdictions except the Province of Quebec and as an investment fund manager in the Provinces of Quebec and Newfoundland and Labrador. The head office of the Filer is in Toronto, Ontario.
The Filer is, or will be, the portfolio manager to the Bridgehouse Funds. Either an affiliate of the Filer or a third party portfolio manager is, or will be, the portfolio sub-advisor to some or all of the Bridgehouse Funds.
Each Bridgehouse Fund is, or will be, a mutual fund created under the laws of the Jurisdiction and is, or will be, subject to the provisions of NI 81-102.
Neither the Filer nor the Bridgehouse Funds are, or will be, in default of securities legislation in any of the Canadian Jurisdictions.
The securities of each Bridgehouse Fund are, or will be, qualified for distribution pursuant to a prospectus that was, or will be, prepared and filed in accordance with the securities legislation of the Canadian Jurisdictions. Accordingly, each Bridgehouse Fund is, or will be, a reporting issuer or the equivalent in each of the Canadian Jurisdictions.
The investment objective and investment strategies of each Bridgehouse Fund permit, or will permit, the Bridgehouse Fund to enter into derivative transactions, including Swaps. Each Portfolio Advisor for the Existing Bridgehouse Funds considers Swaps to be an important investment tool that is available to it to manage each Existing Bridgehouse Fund’s portfolio. Although the Existing Bridgehouse Funds do not currently enter into Swaps, the Portfolio Advisor for the Existing Bridgehouse Funds intends to put in place the arrangements required to permit the Existing Bridgehouse Funds to begin to enter into Swaps.
Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a clearing organization recognized by the CFTC. Generally, where one party to a Swap is a U.S. Person and the other party to the Swap is a mutual fund, such as a Bridgehouse Fund, that Swap must be cleared, absent an available exception, after June 10, 2013. With respect to entities such as the Bridgehouse Funds, the compliance date for the clearing of iTraxx CDS indices was July 25, 2013.
Currently, the Existing Bridgehouse Funds may enter into derivatives on an OTC basis with Canadian, U.S. and other international counterparties. These OTC derivatives are entered into in compliance with the derivative provisions of NI 81-102.
In order to benefit from both the pricing benefits and reduced trading costs that a Portfolio Advisor may be able to achieve through its trade execution practices for its advised investment funds and other accounts and from the reduced costs associated with cleared OTC derivatives as compared to other OTC trades, the Filer wishes to have the Bridgehouse Funds have the ability to enter into cleared Swaps.
In the absence of the Requested Relief, each Portfolio Advisor will need to structure the Swaps entered into by the Bridgehouse Funds so as to avoid the clearing requirements of the CFTC. The Filer respectfully submits that this would not be in the best interests of the Bridgehouse Funds and their investors for a number of reasons, as set out below.
The Filer strongly believes that it is in the best interests of the Bridgehouse Funds and their investors to be able to execute OTC derivatives with U.S. Persons, including U.S. swap dealers.
In its role as a fiduciary for the Bridgehouse Funds, the Filer has determined that central clearing represents the best choice for the investors in the Bridgehouse Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
A Portfolio Advisor may use the same trade execution practices for all of its advised investment funds and other accounts, including the Bridgehouse Funds. An example of these trade execution practices is block trading, where large number of securities are purchased or sold or large derivative trades are entered into on behalf of a number of investment funds and other accounts advised by one Portfolio Advisor. These practices include the use of cleared Swaps if such trades are executed with a U.S. swap dealer. If the Bridgehouse Funds are unable to employ these trade execution practices, then each affected Portfolio Advisor will have to create separate trade execution practices only for the Bridgehouse Funds and will have to execute trades for the Bridgehouse Funds on a separate basis. This will increase the operational risk for the Bridgehouse Funds, as separate execution procedures will need to be established and followed only for the Bridgehouse Funds. In addition, the Bridgehouse Funds will no longer be able to enjoy the possible price benefits and reduction in trading costs that a Portfolio Advisor may be able to achieve through a common practice for its advised funds and other accounts. In the Filer’s opinion, best execution and maximum certainty can best be achieved through common trade execution practices, which, in the case of OTC derivatives, involve the execution of Swaps on a cleared basis.
As a member of the G20 and a participant in the September 2009 commitment of G20 nations to improve transparency and mitigate risk in derivatives markets, Canada has expressly recognized the systemic benefits that clearing OTC derivatives offers to market participants, such as the Bridgehouse Funds. The Filer respectfully submits that the Bridgehouse Funds should be encouraged to comply with the robust clearing requirements established by the CFTC by granting them the Requested Relief.
The Requested Relief is analogous to the treatment currently afforded under NI 81-102 to other types of derivatives that are cleared, such as clearing corporation options, options on futures and standardized futures. This demonstrates that, from a policy perspective, the Requested Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.
For the reasons provided above, the Filer submits that it would not be prejudicial to the public interest to grant the Requested Relief.
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 Requested Relief is granted provided that, in respect of the deposit of cash and portfolio assets as margin:
(a) in Canada,
(i) the Futures Commission Merchant is a member of a SRO that is a participating member of CIPF; and
(ii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the Bridgehouse Fund as at the time of deposit; and
(b) outside of Canada,
(i) the Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to a regulatory audit;
(ii) the Futures Commission Merchant has a net worth, determined from its most recent audited financial statements that have been made public or from other publicly available financial information, in excess of the equivalent of $50 million; and
(iii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the Bridgehouse Fund as at the time of deposit.
This decision will terminate on the earlier of (i) the coming into force of any revisions to the provisions of NI 81-102 that address the clearing of OTC derivatives, and (ii) two years from the date of this decision.
“Vera Nunes”
Vera Nunes
Manager, Investment Funds Branch
Ontario Securities Commission