Pooled Fund Managers Now Have Access to Conflicts of Interest Statutory Relief

On January 6, 2022, amendments to securities regulations took effect which benefit managers of private investment funds (pooled funds)[1]. These amendments allow managers to engage in a variety of transactions that previously were prohibited unless the manager had obtained an exemption order from the securities regulators. While those exemption orders were granted on many occasions, typically they were sought by managers primarily for their public mutual funds, with their pooled funds included as a collateral benefit. Except in limited circumstances, managers of pooled funds did not incur the expense to obtain that same relief. Now, the relief is available without the need for an exemption order and allows pooled funds to:

• Invest in other pooled funds (fund-on-fund investing). Previously, these investments were prohibited if one or more “top” funds under common management owned in aggregate more than 20% of the “bottom” fund. These investments are attractive because they enable the top fund to expose some of its assets to the bottom fund’s diversified portfolio, rather than attempt to replicate it.
• Purchase and sell portfolio securities directly with each other, and with managed accounts of the same manager (inter-fund trading). These trades can be attractive because they are subject to lower transaction costs and can be settled on an expedited basis (particularly between funds and accounts with different immediate cash needs).
• Purchase securities of its parent public company in the secondary market.
• Purchase long-term debt securities of its parent public company during its offering. This added flexibility is attractive due to the relative scarcity of Canadian corporate long-term debt issues.
• Purchase securities that are (or recently were) underwritten by an affiliated dealer, or where the affiliated dealer is selling debt securities as principal.

In each case, the permitted transactions are subject to various conditions. The principal conditions are summarized below.

1. Fund-on-Fund Investing

Fund-on-fund investments now are permitted provided that:

• The bottom fund does not invest more than 10% of its assets in other investment funds (e.g. the bottom fund does not act as a “middle” fund), with certain limited exceptions.
• There is no duplication of management fees charged at the top and bottom funds.
• There are no sales or redemption fees charged to the top fund (unless the bottom fund is arm’s length, in which case transaction fees may be charged to a limited extent).
• The bottom fund prepares prescribed financial reporting.
• The bottom fund does not invest more than 10% of its portfolio in illiquid assets (20% if the bottom fund is a non-redeemable fund).
• The top and bottom funds share the same valuation and redemption dates.
• Certain prescribed disclosure is given to investors in the top fund.

2. Inter-Fund Trading

The main conditions attached to these trades are:

• An independent review committee (IRC) is established to approve the trades. (Such approvals typically are given as a “standing instruction” rather than on a case-by-case basis.) The IRC must follow the same rules that apply to IRCs of public funds.
• The trade is executed at either the end-of-day closing price of the security or its most recent intra-day trading price.
• The trade is subject to “market integrity requirements”, which are requirements to report trades for market transparency purposes.
• If one of the parties to the trade is a managed account, the client of that managed account has approved the trade (typically by way of a general authorization in their investment management agreement).

3. Investing in a Parent Public Company in the Secondary Market

These trades now are permitted, subject to IRC approval (similar to what is described above for inter-fund trading). In the case of listed securities of the parent company, the trade must be made over the exchange (i.e. a secondary market trade, not a purchase from treasury). Where the security is a non-exchange traded debt security of the parent company:

• The debt security must have a designated rating.
• The trade must be executed within prescribed pricing parameters, depending on where it is executed.

4. Invest in Long-Term Debt Securities of a Parent Public Company During Its Offering

These trades now are permitted, subject to the following conditions:

• IRC approval (similar to what is described above for inter-fund trading).
• The debt security (i) has a designated rating, (ii) has a term to maturity greater than 365 days, and (iii) is not asset backed commercial paper.
• The total debt issue is for more than $100 million, and two or more purchasers arm’s length from the company have purchased, in aggregate, at least 20% of the issue.
• Immediately after the purchase (i) the pooled fund has no more than 5% of its net assets invested in debt securities of that company, and (ii) the pooled fund, together with other funds under common management, own no more than 20% of that debt issue.

5. Purchasing Securities From a Related Dealer

In all cases, these trades must be approved by the fund’s IRC and made within certain pricing parameters.

In-Kind Trades Not Permitted

Even though exemption orders have been issued allowing them, these amendments do not include permission to pay for a subscription of pooled fund units with securities (an in-kind purchase), or pay for a redemption of pooled fund units with securities (an in-kind redemption). Managers can continue obtaining exemption orders to permit these in-kind transactions, but they may include new conditions relating to illiquid securities.

Next Steps

Managers of pooled funds wishing to take advantage of this new relief will need to implement various new procedures to satisfy the conditions of the relief. The key changes are:

1. Establish an IRC for those trades that need IRC approval. Securities regulations prescribe various requirements for how an IRC is assembled and operates, including ensuring its independence and setting its own compensation. The IRC will need a “charter” setting out its responsibilities, and IRC members not familiar with their role may need a degree of training. Once established, the IRC will need to approve (typically by “standing instructions”) the trades described above, and usually attach reporting conditions to those approvals. The IRC will continue in place for so long as the pooled funds are holding investments approved by the IRC.
2. Update policies and procedures. A variety of additional requirements associated with these trades will need to be documented in the manager’s policies and procedures. In addition to the technical requirements prescribed by this relief, managers also should set out criteria for ensuring that the trades are done in a manner that serves the bests interests of its clients. New relationship disclosure to managed account clients (including amendments to investment management agreements) also will be triggered.

The Investment Funds practice group at Fasken understands these new requirements and has assisted many clients in the past with obtaining exemption orders for the matters now permitted. Please do not hesitate to reach out to your contact at Fasken if you would like assistance with implementing these changes.

[1] For more detailed information about these amendments see the CSA Notice of Amendments Reducing the Regulatory Burden for Investment Fund Issuers – Phase 2, Stage 1 [PDF] published on October 7, 2021.