October 29, 2024
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
RP INVESTMENT ADVISORS LP (the Filer)
AND
THE Funds
(as defined below)
DECISION
1. Background
The principal regulator in the Jurisdiction has received an application (the Application) from the Filer for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation):
A. revoking the Current Decisions (as defined below) (the Revocation); and
B. replacing the Current Decisions with a decision pursuant to section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102) exempting the following Funds from the following provisions of NI 81-102 as part of facilitating the interest rate risk hedging strategy further described in paragraphs 3(xi) and (xii) below (the Interest Rate Risk Hedging Strategy):
(i) the Conventional Mutual Funds (as defined below) from paragraph 2.6.1(1)(c)(ii) of NI 81-102 to permit these Funds to increase the limit on aggregate short sale exposure to Government Securities (as defined below) of a single issuer from 5% to 20% of the NAV (as defined below) of the applicable Fund (the Conventional Mutual Fund Short Sale Single Issuer Relief);
(ii) the Alternative Mutual Funds (as defined below) from (i) subparagraph 2.6.1(1)(c)(v) of 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 Alternative Mutual Fund exceeds 50% of the Alternative Mutual Fund’s NAV; and (ii) section 2.6.2 of NI 81-102, which states that an Alternative Mutual Fund may not borrow cash or sell 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 Alternative Mutual Fund would exceed 50% of the Fund’s NAV, in order to permit each Alternative Mutual Fund to short sell Government Securities up to a maximum of 300% of its NAV (the Alternative Mutual Fund Short Sale Relief);
(iii) the Conventional Mutual Funds from subsection 2.6.1(2) of NI 81-102 which requires a Conventional Mutual Fund that sells securities short to hold cash cover in an amount that, together with portfolio assets deposited with Borrowing Agents (as defined below) as security in connection with short sales of securities by the mutual fund, is at least 150% of the aggregate market value of the securities sold short by the Conventional Mutual Fund on a daily market-to-market basis in relation to short sales of Government Securities by a Conventional Mutual Fund (the Cash Cover Relief); and
(iv) each of the Funds from the requirement set out 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, 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 a Fund to deposit portfolio assets with a Borrowing Agent that is not the Fund’s custodian or sub-custodian as security in connection with a short sale of securities, provided that 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:
(i) in the case of each Conventional Mutual Fund, exceed 10% of the NAV of the fund at the time of deposit; and
(ii) in the case of each Alternative Mutual Fund, exceed 25% of the NAV of the fund at the time of deposit.
(the Custodial Relief).
(collectively, the Exemptions Sought).
C. Under the Process for Exemptive Relief Applications in Multiple Jurisdictions:
(a) the Ontario Securities Commission is the principal regulator for this 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 each of the other provinces and territories of Canada (together with Ontario, the Jurisdictions).
2. Interpretation
Terms defined in MI 11-102, National Instrument 14-101 – Definitions, NI 81-102, NI 81-107 and NI 31-103 have the same meaning if used in this decision, unless otherwise defined.
The following terms have the following meanings:
Alternative Mutual Fund means a Fund that is an alternative mutual fund, as defined in NI 81-102;
Borrowing Agents means has the meaning set out in NI 81-102;
Conventional Mutual Fund means a Fund that is mutual fund, as defined in NI 81-102, other than an Alternative Mutual Fund;
Current Decisions means, collectively, (i) In the Matter of RP Investment Advisors LP dated December 9, 2019 – (2019), 42 OSCB 9473; and (ii) In the Matter of RP Investment Advisors LP and The Funds dated June 6, 2022 – (2022), 45 OSCB 6255;
Existing Funds means the RP Strategic Income Plus Fund, a Conventional Mutual Fund and the RP Alternative Global Bond Fund, an Alternative Mutual Fund, each of which is a reporting issuer subject to NI 81-102 and for which the Filer currently acts as investment fund manager and portfolio adviser;
Funds means the Existing Funds and any Future Funds;
Future Funds means each future mutual fund that is a reporting issuer subject to NI 81-102 established by the Filer for which the Filer acts as investment fund manager and may act as portfolio manager and that may rely on the Exemptions Sought;
Government Security includes and is limited to: (a) a “government security” as defined in NI 81-102; and (b) an evidence of indebtedness issued, or fully and unconditionally guaranteed as to principal and interest, by any of the federal government of the United Kingdom (U.K.) or the federal government of Germany;
NAV means net asset value; and
Prime Broker means an entity that acts as a prime broker to a Fund.
3. Representations
This decision is based on the following facts represented by the Filer:
The Filer
(i) The Filer is a limited partnership formed under the laws of the Province of Ontario with its head office located in Toronto, Ontario.
(ii) The Filer is registered as (a) an investment fund manager in Ontario, Québec and Newfoundland and Labrador; (b) an adviser in the category of portfolio manager in British Columbia, Ontario and Québec; (c) a dealer in the category of exempt market dealer in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, Québec, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland and Labrador, Northwest Territories, Nunavut and Yukon; and (d) a commodity trading manager in Ontario.
(iii) The Filer is the investment fund manager and portfolio manager of the Existing Funds and the Filer will be the investment fund manager of the Future Funds.
(iv) The Filer is not in default of securities legislation in any of the Jurisdictions.
The Funds
(v) Each of the Existing Funds is an open-ended mutual fund trust established under the laws of the Province of Ontario and is a reporting issuer in each of the Jurisdictions. The RP Strategic Income Plus Fund is a Conventional Mutual Fund subject to NI 81-102 and the RP Alternative Global Bond Fund is an Alternative Mutual Fund subject to NI 81-102. The Future Funds will be Conventional Mutual Funds or Alternative Mutual Funds that are reporting issuers in one or more Jurisdictions and will be subject to NI 81-102. Each of the Funds distributes, or will distribute, its securities to the public pursuant to disclosure documents prepared and filed in accordance with National Instrument 81-101 Mutual Fund Prospectus Disclosure.
(vi) The investment objective of the RP Strategic Income Plus Fund is to generate stable, risk-adjusted absolute returns consisting of dividend, interest income and capital gains by investing primarily in investment grade corporate debt and debt-like securities, with a focus on capital preservation.
(vii) The investment objective of the RP Alternative Global Bond Fund is to generate attractive risk-adjusted returns with an emphasis on capital preservation by investing primarily in investment grade debt and debt-like securities of corporations and financial institutions.
(viii) The investment objective of the Future Funds will generally be to seek to produce risk-adjusted returns through investments in debt and debt-like securities.
(ix) Neither of the Existing Funds is in default of the securities legislation of any of the Jurisdictions.
The Interest Rate Risk Hedging Strategy
(x) Each of the Funds actively invests, or will actively invest, in fixed income instruments of issuers located in Canada, the U.S., the U.K. and Europe and seeks, or will seek, to hedge its interest rate exposure by using a short-selling hedging strategy. Since the value of fixed income securities is influenced by interest rate changes (i.e., bond prices usually decrease as interest rates increase, while bond prices usually increase as interest rates decrease), interest rate volatility can adversely affect a Fund’s performance and impede its ability to achieve stable risk-adjusted returns in a manner that is consistent with its investment objectives.
(xi) In order to hedge against the inherent interest rate risk associated with the corporate fixed income securities invested in by the Funds, the Filer enters into, or will enter into, short selling arrangements relating to Government Securities at the same time that the Fund invests, or will invest, in long positions in the corporate fixed income securities as further described in paragraph (xii) below (the Interest Rate Risk Hedging Strategy). Further, the most effective interest rate hedge occurs where the Government Securities selected by the Filer for hedging purposes most closely correlate to the underlying interest rate characteristics of the particular corporate fixed income securities held by a Fund and, as a result, the Filer cannot remain within the 5% single issuer restriction for Conventional Mutual Funds by using the government securities currently permitted under NI 81-102 and still achieve an optimal interest rate hedge.
The Revocation and Exemptions Sought
(xii) Collectively, the Current Decisions granted the same relief as the Exemptions Sought except that the relief granted under the Current Decisions was limited to “government securities” (as defined by NI 81-102). The Filer is of the view that the Funds would benefit from amending the relief granted in the Current Decisions by expanding the definition of government securities for the purposes of the relief, beyond the definition in NI 81-102 (namely, “an evidence of indebtedness issued, or fully and unconditionally guaranteed as to principal and interest, by any of the government of Canada, the government of a jurisdiction or the government of the United States of America”) to include government securities issued by, or fully and unconditionally guaranteed as to principal and interest by, the federal governments of the U.K. and Germany for the following reasons:
(a) The Filer believes that the investment objectives and hedging strategies of the Funds represent an important investment diversification tool for Canadian investors;
(b) In order to provide investors with a high degree of diversification, and in line with their respective investment objectives the Funds invest, or will invest, in a variety of fixed income securities, including corporate debt securities of Canadian, U.S., U.K. and European issuers in their local markets and currencies;
(c) The Filer seeks greater flexibility to implement its interest rate risk hedging strategy on behalf of the Funds by short selling a wider variety of government securities than is permitted under the Current Decisions. The Filer notes that an increased ability to short sell securities issued by, or fully and unconditionally guaranteed as to principal and interest by, the U.K. and/or German governments in particular will enable the Funds to implement and benefit from more effective interest rate risk hedging strategies;
(d) If a Conventional Mutual Fund utilizes its ability to enter into short sale transactions up to 20% of the Fund’s NAV as permitted under paragraph 2.6.1(c)(iii) of NI 81-102, it would be required to hold on behalf of the Conventional Mutual Fund cash cover equal to 150% of the aggregate market value of such securities, effectively meaning that up to an additional 30% of the Fund’s NAV would need to be held in assets which qualify as cash cover and could not be utilized by the Filer in making investments on behalf of the Fund in furtherance of its investment objectives. The purpose of the cash cover requirements for mutual funds in subsection 2.6.1(2) of NI 81-102 is to mitigate the risk of a mutual fund having to rapidly liquidate large portions of its investment portfolio (at potentially lower prices) in the event that the trading price of the security sold short increases, thereby requiring the mutual fund to repurchase the securities at a higher price in order to satisfy its obligations under the short sale transaction to deliver the securities to the borrowing agent. The Filer believes that exempting the Conventional Mutual Funds from the cash cover requirements in subsection 2.6.1(2) of NI 81-102 in relation to Government Securities would further enhance the ability of the Funds to deploy their assets to: (i) further mitigate risk to the portfolio as a result of greater flexibility to make strategic investments, increase diversification and engage in portfolio rebalancing; and (ii) maximize returns to security holders without materially increasing the risk to the Funds relating to the ability to settle such short sale transactions;
(e) Each of the U.K. and Germany is a G7 member alongside Canada and the U.S. and the debt securities of each of these countries remains highly rated by independent credit rating agencies. Currently, the government debt of all four of these countries is rated AA or higher by Standard & Poor’s, with similarly high ratings from other major ratings agencies;
(f) German government securities are highly liquid and stable securities that, in the Filer’s experience, can effectively be utilized as part of the short selling interest rate risk hedging strategies utilized by the Funds in relation to Euro denominated fixed income securities issued by corporate entities not just within Germany but also the broader European Union;
(g) The markets for securities issued by the governments of the U.K. and Germany are highly developed and can provide superior liquidity and risk mitigation opportunities compared to the use of Canadian and U.S. government securities when the goal is to minimize the risks associated with investments in U.K. and European fixed income securities;
(h) Unlike the short selling of equity securities, the total possible loss when short selling government issued securities is quantifiable at time of trade. The total exposure to loss on the short sale of a government security is the sum of all future coupon payments on the security, plus the difference between the trade price and par value of the security. As a result, the Funds are not (or will not be) exposed to any greater risk of significant losses by engaging in the short selling of government securities of the U.K. or Germany;
(i) The Filer has experience managing the strategies described herein in the Existing Funds as well as in privately offered investment funds under its management;
(j) While derivatives may be used to manage interest rate risk, the Filer views the use of derivatives in an interest rate risk hedging strategy as more inefficient, complex and potentially riskier than a hedging strategy of managing interest rate risk through the physical short selling of Government Securities which has been demonstrated to be an effective and economically efficient strategy to mitigate the interest rate risk that is inherent in investments in corporate fixed income securities;
(k) The Filer believes that the Funds will not be exposed to any greater risk of significant losses by engaging in the short selling of securities issued by the governments of the U.K. and/or Germany; and
(l) The Filer believes that permitting the Funds to engage increased short selling of securities issued by the governments of the U.K. and/or Germany in accordance with the terms of this decision, which are consistent with the terms of the Current Decisions, will maximize the assets of the Funds which can be deployed in furtherance of the investment objectives of the Funds without increasing the risk to the Funds relating to the settlement of such short sale transactions.
(xiii) in connection with the Current Decisions, the Funds have implemented the following controls when conducting a short sale and will continue to observe same under this decision:
(a) the Fund assumes the obligation to return to the Borrowing Agent the securities borrowed to effect the short sale;
(b) the Fund receives cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer monitors (or will monitor) the short positions of the Fund at least as frequently as daily;
(d) the security interest provided by a Fund over any of its assets that is required to enable the Fund to effect a short sale transaction is made in accordance with section 6.8.1 of NI 81-102 and with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Fund maintains 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;
(f) The Filer and the Fund keep proper books and records of short sales and all of its assets are deposited with Borrowing Agents as security; and
(g) Each Alternative Mutual Fund’s aggregate exposure to short selling, cash borrowing and specified derivatives transactions used for purposes other than hedging will not exceed 300% of the Alternative Mutual Fund’s NAV, in compliance with section 2.9.1 of NI 81-102 (the Aggregate Exposure Limit).
(xiv) The Filer wishes to amend the Current Decisions to include the Conventional Mutual Fund Short Sale Single Issuer, the Alternative Mutual Fund Short Sale Relief and the Cash Cover Relief and to maintain the Custodial Relief (further referenced below) by revoking the Current Decisions and replacing them with the relief granted under this decision.
The Custodial Relief
(xv) 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, a Borrowing Agent that is a Prime Broker.
(xvi) If a Conventional Mutual Fund engages as its Prime Broker an entity that is not its custodian or sub-custodian, then it 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 NAV of the Conventional Mutual Fund at the time of deposit. If an Alternative Mutual Fund engages as its Prime Broker an entity that is not its custodian or sub-custodian, then it 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 NAV of the Alternative Mutual Fund at the time of deposit
(xvii) A Prime Broker may not wish to act as Borrowing Agent for a Conventional Mutual Fund that wants to sell short securities having an aggregate market value of up to 20% of the Conventional Mutual Fund’s NAV 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 NAV of the Conventional Mutual Fund.
(xviii) The issue is even greater in the context of an Alternative Mutual Fund, as a Prime Broker will not act as Borrowing Agent for an Alternative Mutual Fund that wants to sell short securities having an aggregate market value of up to 50% of the Alternative Mutual Fund’s NAV 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 NAV of the Alternative Mutual Fund.
(xix) 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 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.
(xx) 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 NAV limitations set out in section 6.8.1 of NI 81-102 apply, then the Funds will need to retain two, or more, 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.
(xxi) The requirement for additional Prime Brokers increases costs for the Fund, which will reduce returns and negatively impact investors.
(xxii) The Filer submits that it would not be prejudicial to the public interest to maintain the Custodial Relief.
4. 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:
A. The Revocation is granted; and
B. The Exemptions Sought are granted provided that:
(a) each short sale will be made consistent with the Fund’s investment objectives, Interest Rate Risk Hedging Strategy and other investment strategies;
(b) the Conventional Mutual Fund Short Sale Single Issuer Relief, the Alternative Mutual Fund Short Sale Relief and the Cash Cover Relief will apply (i) only to short sales of Government Securities; and (ii) only as part of the Fund’s Interest Rate Risk Hedging Strategy;
(c) In respect of the Conventional Mutual Fund Short Sale Single Issuer Relief and the Cash Cover Relief:
(i) the security interest provided by a Fund over any of its assets that is required to effect a short sale transaction is made in accordance with industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(ii) each short sale made by a Fund will otherwise comply with the mutual fund short sale requirements in section 2.6.1 of NI 81-102;
(iii) the Filer monitors the short positions of the Funds at least as frequently as daily;
(iv) the Funds 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;
(v) the Filer and the Funds keep proper books and records of short sales and all assets of the Funds deposited with Borrowing Agents as security; and
(vi) the prospectus of the Funds will disclose the material terms and conditions of the Conventional Mutual Fund Short Sale Single Issuer Relief and the Cash Cover Relief including its restricted application to short sales of Government Securities;
(d) In respect of the Alternative Mutual Fund Short Sale Relief:
(i) the only securities which an Alternative Mutual Fund will sell short in an amount that exceeds 50% of the Alternative Mutual Fund’s NAV will be Government Securities (as such term is defined above);
(ii) each short sale by an Alternative Mutual Fund will otherwise comply with all of the short sale requirements applicable to alternative mutual funds in sections 2.6.1 and 2.6.2 of NI 81-102;
(iii) an Alternative Mutual Fund’s aggregate exposure to short selling, cash borrowing and specified derivatives used for purposes other than hedging will not exceed the Aggregate Exposure Limit; and
(iv) each Alternative Mutual Fund’s Prospectus will disclose that the Alternative Mutual Fund is able to short sell “Government Securities” (as defined above) in an amount up to 300% of the Alternative Mutual Fund’s NAV, including the material terms of this decision; and
(e) In respect of the Custodial Relief, the Funds otherwise comply with subsections 6.8.1(2) and (3) of NI 81-102.
“Darren McKall”
Darren McKall, Manager Investment Management Division Ontario Securities Commission
Application No. 2024/0430
SEDAR Project No. 6158292