Securities Law & Instruments

Headnote

Mutual Reliance Review System for Exemptive Relief Applications -- s. 19.1 of National Instrument 81-102 Mutual Funds -- exemption from section 2.7 (1)(a) of NI 81-102 insofar as it requires an interest rate swap to have a remaining term to maturity of 3 years (or 5 years in certain circumstances) to permit existing and future funds which have as their investment objective income or a balance amongst income and other asset classes, to enter into an interest rate swap or a credit default swap, or if the transaction is for hedging purposes, currency forwards, with a remaining term to maturity of greater than 3 years; and exemption from sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the Funds when they open or maintain a long position in a standardized future or forward contract or when they enter into or maintain an interest rate swap position and during the periods when the Funds are entitled to receive payments under the interest rate swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap -- the relief will enhance returns to investors while still providing adequate safeguards.

Applicable Legislative Provisions

National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 2.8(1)(d), 2.8(1)(f)(i), 19.1.

January 8, 2007

IN THE MATTER OF

THE SECURITIES LEGISLATION OF

BRITISH COLUMBIA, ALBERTA, SASKATCHEWAN,

MANITOBA, ONTARIO, QUEBEC, NEW BRUNSWICK,

NOVA SCOTIA, PRINCE EDWARD ISLAND,

NEWFOUNDLAND AND LABRADOR, NORTHWEST

TERRITORIES, NUNAVUT and YUKON

(THE JURISDICTIONS)

AND

IN THE MATTER OF

THE MUTUAL RELIANCE REVIEW SYSTEM

FOR EXEMPTIVE RELIEF APPLICATIONS

AND

IN THE MATTER OF

AIM FUNDS MANAGEMENT INC. (THE FILER)

AND

THE FUNDS LISTED IN APPENDIX A

AND APPENDIX B

 

MRRS DECISION DOCUMENT

Background

The local securities regulatory authority or regulator (the Decision Maker) in each of the Jurisdictions has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation) granting exemptions pursuant to Section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102) in respect of,

1. the funds set out in Appendix A, together with all future funds managed by the Filer which have as their investment objective income or a balance amongst income and other asset classes (collectively, the Income and Balanced Funds), from the requirement in section 2.7 (1)(a) of NI 81-102, insofar as it requires a swap to have a remaining term to maturity of 3 years (or 5 years in certain circumstances), to permit the Income and Balanced Funds to enter into an interest rate swap or credit default swap or, if the transaction is for hedging purposes, currency forwards, in all cases with a remaining term to maturity of greater than 3 years; and

2. the funds set out in Appendix B, together with all future funds managed by the Filer (collectively, the AIM Trimark Funds), from the requirement in sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the AIM Trimark Funds when,

(a) they open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract or in a standardized future or forward contract; or

(b) they enter into or maintain a swap position and during the periods when the AIM Trimark Funds are entitled to receive payments under the swap;

to use as cover, a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap;

(paragraphs 1 and 2 collectively will be referred to as the Requested Relief).

Under the Mutual Reliance Review System for Exemptive Relief Applications:

(a) Ontario is the principal regulator for this application, and

(b) this MRRS decision document evidences the decision of each Decision Maker.

Interpretation

Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are defined in this decision.

Representations

This decision is based on the following facts represented by the Filer:

The Funds

1. The AIM Trimark Funds are mutual fund trusts or classes of corporations established in Ontario for which the Filer is the manager. The investment manager is either the Filer or another entity appointed by the Filer as sub-advisor. The AIM Trimark Funds are offered by prospectus in all the Jurisdictions. The AIM Trimark Funds are reporting issuers. The Filer's head office is in Toronto, Ontario.

2. The investment objective and strategies of each AIM Trimark Fund are set out in the Fund's simplified prospectus. In some cases, the primary investment objective is to invest in, or gain exposure to, fixed income securities, such as bonds and debentures issued by governments and corporations, or a combination of fixed income and equities. In other cases, the investment objective is focused primarily on equities but the AIM Trimark Fund retains the right to include a portion in fixed income either routinely or under conditions determined by the manager.

3. In all cases, hedging of risks is permitted, including currency risks, whether the currency risk relates to income or equity securities or other securities.

Interest Rate Swaps, Credit Default Swaps, and Currency Forwards for Hedging Purposes

4. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into swaps or currency forwards with terms to maturity of greater than three years, or greater than five years if the contract provides the fund with a right to eliminate its exposure within three years. The Filer seeks the ability to enter into interest rate swaps or credit default swaps for the Income and Balanced Funds or, if the transaction is for hedging purposes, currency forwards on behalf of the Income and Balanced Funds without a restriction as to term of the swap or forward.

5. Fixed income investments have risks which include (but are not limited to) interest rate risk, credit risk and currency risk. These risks can be controlled or mitigated through the use of over-the-counter (OTC) derivatives. Interest rate risk may be managed by interest rate swaps, credit risk is managed by credit default swaps and currency risk by currency forwards.

6. The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter transactions, such as options and certain other types of forwards, where the contract term and maturity of the underlying security are not related. As a result, there is no restriction under NI 81-102, for example, on a forward referencing an underlying interest having a term of 10 years whereas there is a restriction if the derivative is in the form of a swap.

7. Credit default swaps (CDS) have a similar risk profile to their reference entity (corporate or sovereign bonds), or in the case of an index of credit default swaps (CDX), to an average of all the reference entities in the CDX index. The term of a credit default swap imparts credit risk similar to that of a bond of the reference entity with the same term. The Income and Balanced Funds may not be able to achieve the same sensitivity to credit risk as their respective benchmarks by using credit default swaps with a maximum term of 3 years because the relevant benchmark may have an average term that is longer. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).

8. A currency forward used for hedging purposes may or may not have a contract term and maturity that equals the maturity of the underlying interest. For example, if a 10 year bond is denominated in U.S. dollars, under the current provisions of NI 81-102, the term of the currency forward can be at most 5 years whereas the term of the underlying interest is 10 years. Ideally to manage the currency risk, a fund must enter into two consecutive 5-year currency forwards. However, the pricing for the currency forward in respect of the second 5 year period is not known at the time the U.S. dollar bond is purchased but only 5 years hence. Consequently, the inability to enter into a 10 year currency forward transaction indirectly introduces currency risk when a hedged 10 year position was the desired outcome. Accordingly, whenever the term of the bond is longer than 5 years, a fund may be exposed to currency risk. This has become a very relevant issue given that there are no longer foreign investment restrictions under the Income Tax Act (Canada). It should also be noted that it is not market convention to have a transaction with a 5 year term (subject to a right to eliminate the exposure within 3 years) and as a result, from time to time, this off-market feature may subject a fund to less efficient pricing.

9. The interest rate swap market, credit default swap markets and currency forward markets are very large and liquid.

10. The interest rate swap market is generally as liquid as government bonds and more liquid than corporate bonds. The Bank for International Settlements reported that the notional amount of interest rate swaps outstanding was U.S. $172.8 trillion as of December 31, 2005. In Canada, there were over U.S. $1.5 trillion of interest rate swaps outstanding as of such date, greater than the sum of all outstanding federal and provincial debt.

11. Credit default swaps, on average, are highly liquid instruments. Single name CDS are slightly less liquid than the bonds of their reference entities, while CDS on CDX are generally more liquid, than corporate or emerging market bonds. The Bank for International Settlements reported that the notional amount of credit default swaps outstanding was U.S. $9.7 trillion as of December 31, 2005. The International Swap and Derivatives Association's 2005 mid-year market survey estimated the notional amount outstanding to be U.S. $12.4 trillion. Using either source, the credit default swap market has surpassed the size of the equity derivatives markets, and is one of the fastest growing financial markets.

12. With respect to foreign exchange, the Bank for International Settlements reported that the notional amount of outright forwards and foreign exchange swaps outstanding was U.S. $15.9 trillion as at December 31, 2005. For comparative purposes, the S & P 500 had an estimated market capitalization of U.S. $11.6 trillion on such date. The Bank for International Settlements also reported that the average daily turnover of OTC foreign exchange was U.S. $1,292 billion during April, 2004. The average daily turnover of outright forwards and foreign exchange swaps totaled U.S. $1,152 billion during such period. For comparative purposes, the daily trading during July 2006 was in the case of the New York Stock Exchange approximately U.S. $65.3 billion and in the case of the Toronto Stock Exchange approximately CAD $5.1 billion. Daily trading is many times larger for currencies and currency forwards than for well-known equity exchanges.

13. Because swap and forward contracts are private agreements between two counterparties, a secondary market for the agreements would be a cumbersome process whereby one counterparty would have to find a new counterparty willing to take over its contract at a fair market price, get the original counterparty to approve the new counterparty, and exchange a whole new set of documents. To avoid that process, market participants can unwind their positions in interest rate swaps and currency forwards by simply entering into an opposing swap with an acceptable counterparty at market value. In this way, the original economic position of the initial swap or forward is offset.

14. Credit risk exposure to a counterparty on interest rate swap transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102.

15. Potential credit exposure to a counterparty on a credit default swap on a CDX is equal to the notional exposure to any issuer in the index who has defaulted, or in the case of a single name CDS, equal to the full notional exposure. As is the case with interest rate swaps, this exposure is mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102 and exposure to any individual counterparty is limited by NI 81-102.

16. By permitting the Income and Balanced Funds to enter into swaps beyond 3 year terms, it increases the possibility for the Income and Balanced Funds to (i) increase returns due to the fact that the opportunity set is expanded, and (ii) to target exposures that might not otherwise be available in the cash bond markets or could not be achieved as efficiently as in the cash bond markets. Further, the use of swaps and forwards beyond 3 year terms enables the Income and Balanced Funds to effect hedging transactions that help mitigate underlying investment risks associated with investing in fixed income investments.

Using Put Options as Cover for Long Positions in Futures, Forwards and Swaps

17. Sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 do not permit covering the position in long positions in futures and forwards and long positions in swaps for a period when an AIM Trimark Fund is entitled to receive payments under the swap, in whole or in part with a right or obligation to sell an equivalent quantity of the underlying interest of the future, forward or swap. In other words, those sections of NI 81-102 do not permit the use of put options or short future positions to cover long future, forward or swap positions.

18. Regulatory regimes in other countries recognize the hedging properties of options for all categories of derivatives, including long positions evidenced by standardized futures or forwards or in respect of swaps where a fund is entitled to receive payments from the counterparty, provided they are covered by an amount equal to the difference between the market price of a holding and the strike price of the option that was bought or sold to hedge it. NI 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the fund under the scenario described is equal to the difference between the market value of the long and the exercise price of the option. Overcollateralization imposes a cost on a fund.

19. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with buying a put option on an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a long position in a future, forward or swap and therefore, the Filer submits that the AIM Trimark Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future position.

Derivative Policies and Risk Management

20. The Filer and each sub-advisor has its own written policies and procedures relating to the use of derivatives for the AIM Trimark Funds for which it has been appointed portfolio manager.

21. These policies and procedures are reviewed at least annually by senior management of the sub-advisor and the Filer. The Chief Investment Officer of the Filer is responsible for oversight of all derivatives strategies used by the AIM Trimark Funds. In addition, compliance personnel employed by both the sub-advisor and the Filer review the use of derivatives as part of their ongoing review of AIM Trimark Fund activity. Compliance personnel are not members of the investment and trading group and report to a different functional area.

22. Limits and controls on the use of derivatives are part of the Filer's fund compliance regime and include reviews by analysts who ensure that the derivative positions of the AIM Trimark Funds are within applicable policies. As the use of the derivatives by the AIM Trimark Funds is limited, the Filer does not currently conduct simulations to test the portfolio under stress conditions.

23. The derivative contracts entered into by the Filer or sub-advisor on behalf of the AIM Trimark Funds must be in accordance with the investment objectives and strategies of each of the AIM Trimark Funds. The Filer and sub-advisor are also required to adhere to NI 81-102. The Filer sets and reviews the investment policies of the AIM Trimark Funds, which also allows the trading in derivatives.

24. The prospectuses and annual information forms of the Income and Balanced Funds and the AIM Trimark Funds disclose the internal controls and risk management processes of the Filer regarding the use of derivatives and, upon renewal and all subsequent renewals, will include disclosure of the nature of the exemptions granted in respect of the Income and Balanced Funds and the AIM Trimark Funds.

25. Without these exemptions, the Income and Balanced Funds and the AIM Trimark Funds will not have the flexibility to enhance yield and to manage more effectively the exposures under specified derivatives.

Decision

Each of the Decision Makers is satisfied that the test contained in the Legislation that provides the Decision Maker with the jurisdiction to make the Decision has been met. The decision of the Decision Makers under the Legislation is that the Requested Relief is granted provided that:

(i) an AIM Trimark Fund shall not open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract, or in a standardized future or forward contract unless an AIM Trimark Fund holds:

(a) cash cover in an amount that, together with margin on account for the specified derivative and the market value of the specified derivative, is not less than, on a daily mark-to-market basis, the underlying market exposure of the specified derivative;

(b) a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and cash cover that together with margin on account for the position, is not less than the amount, if any, by which the strike price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest;

(c) a combination of the positions referred to in subparagraphs a) and b) that is sufficient, without recourse to other assets of the AIM Trimark Fund, to enable the AIM Trimark Fund to acquire the underlying interest of the future or forward contract;

(ii) an AIM Trimark Fund shall not enter into or maintain an interest rate swap position unless for periods when the AIM Trimark Fund would be entitled to receive payments under the swap, the AIM Trimark Fund holds

(a) cash cover in an amount that, together with margin on account for the swap and the market value of the swap, is not less than, on a daily mark-to-market basis, the underlying market exposure of the swap;

(b) a right or obligation to enter into an offsetting interest rate swap on an equivalent quantity and with an equivalent term and cash cover that together with margin on account for the position is not less than the aggregate amount, if any, of the obligations of the AIM Trimark Fund under the interest rate swap less the obligations of the AIM Trimark Fund under such offsetting interest rate swap;

(c) a combination of the positions referred to in clauses a) and b) that is sufficient, without recourse to other assets of the AIM Trimark Fund, to enable the AIM Trimark Fund to satisfy its obligations under the interest rate swap; and

(iii) At the time of the next renewal and all subsequent renewals of the prospectus and annual information form of the Income and Balanced Funds and/or the AIM Trimark Funds, each of the Income and Balanced Funds and the AIM Trimark Funds shall disclose the nature of this relief in each fund's prospectus under the Investment Strategies section and the nature and terms of the relief in the fund's annual information form.

"Leslie Byberg"
Manager, Investment Funds Branch
Ontario Securities Commission

 

APPENDIX A

Income and Balanced Funds

Fixed-Income Funds

1. Trimark Government Plus Income Fund

2. Trimark Canadian Bond Fund

3. Trimark Floating Rate Income Fund

4. Trimark Advantage Bond Fund

5. Trimark Global High Yield Bond Fund

Balanced Funds

6. Trimark Diversified Income Class{†}

7. Trimark Global Balanced Class{•}

8. AIM Canadian Balanced Fund

9. AIM Trimark Core Canadian Balanced Class{†}

10. Trimark Income Growth Fund

11. Trimark Select Balanced Fund

12. Trimark Global Balanced Fund

13. Trimark Monthly Income Private Pool{•}

14. Trimark World Balanced Private Pool{•}

15. Trimark World Balanced Private Pool -- Currency Neutral{•}

{†} Part of AIM Trimark Canada Fund Inc.

{•} Part of AIM Trimark Corporate Class Inc. (formerly AIM Trimark Global Fund Inc.)

 

APPENDIX B

AIM Trimark Funds

Fixed-Income Funds

1. Trimark Government Plus Income Fund

2. Trimark Canadian Bond Fund

3. Trimark Floating Rate Income Fund

4. Trimark Advantage Bond Fund

5. Trimark Global High Yield Bond Fund

Balanced Funds

6. Trimark Diversified Income Class{†}

7. Trimark Global Balanced Class{•}

8. AIM Canadian Balanced Fund

9. AIM Trimark Core Canadian Balanced Class{†}

10. Trimark Income Growth Fund

11. Trimark Select Balanced Fund

12. Trimark Global Balanced Fund

13. Trimark Monthly Income Private Pool{•}

14. Trimark World Balanced Private Pool{•}

15. Trimark World Balanced Private Pool -- Currency Neutral{•}

Canadian Equity Funds

16. AIM Trimark Core Canadian Equity Class{†}

17. AIM Canadian First Class{†}

18. AIM Canadian Premier Class{†}

19. AIM Canadian Premier Fund

20. Trimark Canadian Fund

21. Trimark Canadian Endeavour Fund

22. Trimark Select Canadian Growth Fund

23. Trimark Canadian Small Companies Fund

24. AIM Canadian Equity Growth Private Pool{•}

25. Trimark Canadian Equity Private Pool{•}

American Equity Funds

26. AIM Trimark Core American Equity Class{•}

27. Trimark U.S. Companies Class{•}

28. AIM American Mid Cap Growth Class{•}

29. Trimark U.S. Small Companies Class{•}

30. AIM American Growth Fund

31. Trimark U.S. Companies Fund

32. Trimark U.S. Equity Private Pool{•}

33. Trimark U.S. Equity Private Pool -- Currency Neutral{•}

Global Equity Funds

34. AIM Trimark Core Global Equity Class{•}

35. Trimark Select Growth Class{•}

36. AIM Global Theme Class{•}

37. Trimark Global Endeavour Class{•}

38. AIM International Growth Class{•}

39. AIM European Growth Class{•}

40. AIM European Growth Fund

41. Trimark Fund

42. Trimark Select Growth Fund

43. Trimark Global Endeavour Fund

44. Trimark International Companies Fund

45. Trimark Europlus Fund

46. AIM Indo-Pacific Fund

47. AIM EAFE Equity Growth Private Pool{•}

48. Trimark EAFE Equity Private Pool{•}

49. Trimark Global Equity Private Pool{•}

50. Trimark Global Equity Private Pool -- Currency Neutral{•}

51. Trimark Global Mid-Cap Equity Private Pool{•}

Sector Funds

52. AIM Global Health Sciences Class{•}

53. AIM Global Technology Class{•}

54. AIM Global Health Sciences Fund

55. AIM Global Technology Fund

56. Trimark Canadian Resources Fund

57. Trimark Discovery Fund

{†} Part of AIM Trimark Canada Fund Inc.

{•} Part of AIM Trimark Corporate Class Inc. (formerly AIM Trimark Global Fund Inc.)