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. and European requirements to clear over-the-counter derivatives including swaps -- decision treats cleared swaps similar to other cleared derivatives -- National Instrument 81-102 Investment Funds; relief from sections 2.8(1)(d) and (f)(i) of NI 81-102 to permit the funds when they open or maintain an interest rate swap position and during the periods when the funds are entitled to receive payments under the swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.7(1), 2.7(4), 2.7(1)(d), 2.7(1)(f)(i), 6.1(1), 19.1
June 29, 2016
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 ARROW CAPITAL MANAGEMENT INC. (the Filer)
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 paragraph 19.1 of National Instrument 81-102 Investment Funds (NI 81-102), exempting each Existing Arrow Fund (as defined below) and all current and future mutual funds managed by the Filer in the future (each, a Future Arrow Fund and, together with the Existing Arrow Funds, each, an Arrow Fund and, collectively, the Arrow Funds):
(i) with respect to cleared Swaps, from the requirement in section 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) with respect to cleared Swaps, from the limitation in section 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;
(iii) with respect to cleared Swaps, from the requirement in section 6.1(1) of NI 81-102 to hold all portfolio assets of an investment fund under the custodianship of one custodian in order to permit each Arrow Fund to deposit cash and portfolio assets directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) as margin; and
(iv) from the requirement in sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 in order to permit each of the Arrow Funds when it:
(A) opens or maintains 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) enters into or maintains a swap position and during the periods when the Arrow Fund is 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,
(the relief from the requirements described in paragraphs (i), (ii) and (iii) are collectively referred to as the Cleared Derivatives Relief and the relief from the requirements described in paragraph (iv) are collectively referred to as the Derivative Cover Relief, and together with the Cleared Derivatives Relief, collectively referred to as 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 (collectively, with Ontario, the Jurisdictions).
Terms defined in MI 11-102, National Instrument 14-101 Definitions and NI 81-102 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 clearing agency that acts as counterparty to each party for each Swap for which it provides clearing services and is a clearing organization registered with the CFTC or central counterparty authorized by ESMA, as the case may be, that, in either case, is also permitted to operate in the jurisdiction of Canada where the Arrow Fund is located
Dodd-Frank means the Dodd-Frank Wall Street Reform and Consumer Protection Act EMIR means the European Market Infrastructure Regulation
ESMA means the European Securities and Markets Authority
European Economic Area means all of the European Union countries and also Iceland, Liechtenstein and Norway
Existing Arrow Fund means each mutual fund managed by the Filer that is listed on Schedule "A" to this decision
Futures Commission Merchant means any futures commission merchant that is registered with the CFTC and/or is a clearing member for purposes of EMIR, as applicable 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 to sub-advise the investment portfolio of one or more Arrow Funds
Swaps means the swaps that are, or will become, subject to a clearing determination or a clearing obligation issued by the CFTC or ESMA, as the case may be
U.S. Person has the meaning attributed thereto by the CFTC
This decision is based on the following facts represented by the Filer:
The Filer and Arrow Funds
1. The Filer is, or will be, the investment fund manager of each Arrow Fund. The Filer is a corporation incorporated under the Business Corporations Act (Ontario) with its head office located in Toronto, Ontario.
2. The Filer is registered in the following categories in certain of the Jurisdictions indicated below:
(a) Ontario: Portfolio Manager (PM), Investment Fund Manager (IFM); Exempt Market Dealer (EMD) and Commodity Trading Manager under the Commodity Futures Act (Ontario);
(b) Alberta: EMD;
(c) British Columbia: EMD;
(d) Quebec: EMD and IFM; and
(e) Newfoundland and Labrador: IFM.
3. The Filer is, or will be, the manager of the Arrow Funds. Another Portfolio Advisor is, or will be, the sub-advisor to certain of the Arrow Funds.
4. Each Arrow Fund is, or will be, a mutual fund created under the laws of the Province of Ontario and is, or will be, subject to the provisions of NI 81-102.
5. Neither the Filer nor the Arrow Funds are, or will be, in default of securities legislation in any of the Jurisdictions.
6. The securities of each Arrow 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 Jurisdictions; accordingly, each Arrow Fund is, or will be, a reporting issuer or the equivalent in each of the Jurisdictions.
Cleared Swaps and Put Option Cover
7. The investment objective and investment strategies of each Arrow Fund permit, or will permit, the Arrow Fund to enter into derivative transactions, including Swaps, put options and short future positions. The Portfolio Advisors for the Existing Arrow Funds consider specified derivative positions, including Swaps, put options and short future positions, to be an important investment tool that is available to it to properly manage and hedge each Arrow Fund's portfolio, as applicable.
8. Each of the Existing Arrow Funds have entered into, or intend to enter into, foreign exchange swaps, interest rate swaps and credit default swaps on single names and indices. Each of the Existing Arrow Funds have entered into, or intend to enter into, to use specified derivatives to hedge against losses caused by changes in securities prices, interest rates, exchange rates and/or other risks. The Arrow Funds may also use specified derivatives for non-hedging purposes under their investment strategies in order to invest indirectly in securities or financial markets or to gain exposure to other currencies, provided the use of specified derivatives is consistent with the particular Arrow Fund's investment objective(s). When specified derivatives are used for non-hedging purposes, the Arrow Funds are subject to the cover requirements of NI 81-102.
9. Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a Clearing Corporation. Generally, where one party to a Swap is a U.S. Person, that Swap must be cleared, absent an available exception.
10. EMIR requires that certain OTC derivatives be cleared through a central counterparty authorized to provide clearing services for purposes of EMIR. Generally, where one party to a Swap is a financial counterparty or a non-financial counterparty whose OTC derivative trading activity exceeds a certain threshold, in each case established in a state that is a participant in the European Economic Area, that Swap will be required to be cleared. The first clearing directive has been issued in respect of certain interest rate swaps and will be phased-in based on the category of both parties to the trade.
11. In order to benefit from both the pricing benefits and reduced trading costs that a Portfolio Advisor is often able to achieve through its trade execution practices for its managed investments funds and from the reduced costs associated with cleared OTC derivatives as compared to other OTC trades, the Filer wishes to have the Arrow Funds enter into cleared Swaps.
12. 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 a 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.
13. 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 over-collateralize, 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 and as a result overcollateralization imposes a cost on a fund.
14. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with 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 Arrow Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future position.
15. In order to benefit from reduced trading costs and more cost-efficient use of portfolio assets, while still affording the Arrow Funds the ability to hedge certain of its specified derivative positions, the Filer wishes to have the Arrow Funds to use put options or short future position to cover a long position in a future, forward or swap.
Derivative Policies and Risk Management
16. The Filer, in its capacity as manager and portfolio advisor, has or will set and review the investment objectives and overall investment policies of the Arrow Funds, which generally will allow for trading in derivatives. The derivative contracts entered into by or on behalf of the Arrow Funds must be in accordance with the investment objectives and strategies of each of the Funds and in compliance with NI 81-102.
17. The Filer in its capacity as portfolio advisor is or will be generally permitted to use derivatives for the Arrow Funds under certain conditions and limitations in order to gain exposure to financial markets or to invest indirectly in securities or other assets. The Filer, in its capacity as Portfolio Advisor, may similarly allow any portfolio sub-advisors to use derivatives.
18. The Chief Compliance Officer of the Filer is responsible for establishing and maintaining policies and procedures in connection with the use of derivatives, oversight of all derivative strategies used by the Arrow Funds, and the monitoring and assessing compliance with all applicable legislation. The Chief Compliance Officer is required to report to the Ultimate Designated Person of the Filer on any instances of non-compliance and reports to the board of directors of the Filer on his or her compliance assessments. The board of directors of the Filer reviews and approves the Filer's policies and procedures in connection with the use of derivatives and has the ultimate responsibility of ensuring that proper policies and procedures relating to the use of derivatives are in place. Any portfolio sub-advisor to the Arrow Funds would be required to have similar appropriate policies and procedures.
19. The simplified prospectus and annual information form of the Arrow Funds does or will include disclosure of the nature of the exemptions granted in respect of the Arrow Funds.
Absence of the Requested Relief
20. In the absence of the Cleared Derivative Relief, each Portfolio Advisor will need to structure the Swaps entered into by the Arrow Funds so as to avoid the clearing requirements of the CFTC and under EMIR, as applicable. The Filer respectfully submits that this would not be in the best interests of the Arrow Funds and their investors for a number of reasons, as set out below.
21. The Filer strongly believes that it is in the best interests of the Arrow Funds and their investors to execute OTC derivatives with global counterparties.
22. In its role as a fiduciary for the Arrow Funds, the Filer has determined that central clearing represents the best choice for the investors in the Arrow Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
23. A Portfolio Advisor currently uses the same trade execution practices for all of its managed funds, including the Arrow Funds. These practices include the use of cleared Swaps. In the absence of the Cleared Derivative Relief, the Portfolio Advisor has to create separate trade execution practices only for the Arrow Funds and has to execute trades for the Arrow Funds on a separate basis. This increases the operational risk for the Arrow Funds, as separate execution procedures are needed only for the Arrow Funds. In addition, the Arrow Funds are unable to enjoy the possible price benefits and reduction in trading costs that the Portfolio Advisor may be able to achieve through a common practice for its family of investment funds. 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.
24. The Cleared Derivative Relief is analogous to the treatment currently afforded under NI 81-102 to other types of derivatives that are cleared, i.e., clearing corporation options, options on futures and standardized futures. This clearly demonstrates that, from a policy perspective, the Cleared Derivative Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.
25. In the absence of the Cleared Derivative Relief, the Arrow Funds will not have the flexibility to enhance yield and to more effectively manage the exposures under specified derivatives through the use of put options or short future positions to cover long future, forward or swap positions.
26. For the reasons provided above, the Filer submits that it would not be prejudicial to the public interest to grant the Requested Relief.
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:
(a) when any rules applicable to customer clearing of OTC derivatives come into force, the Clearing Corporation is permitted to offer customer clearing of OTC derivatives in the jurisdictions of Canada where the Arrow Fund is located and provided further that, in respect of the deposit of cash and portfolio assets as margin:
(i) in Canada;
(A) the Futures Commission Merchant is a member of a SRO that is a participating member of CIPF; and
(B) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount f margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the Arrow Fund as at he time of deposit; and
(ii) outside of Canada:
(A) the Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to a regulatory audit;
(B) 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
(C) 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 Arrow Fund as at he time of deposit;
(b) when an Arrow Fund enters into or maintains a swap position for periods when the Arrow Fund would be entitled to receive fixed payments under the swap, the Arrow Fund holds:
(i) 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;
(ii) a right or obligation to enter into an offsetting 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 Arrow Fund under the swap less the obligations of the Arrow Fund under such offsetting swap; or
(iii) a combination of the positions referred to in clauses (i) and (ii) that is sufficient, without recourse to other assets of the Arrow Funds, to enable the Arrow Funds to satisfy its obligations under the swap;
(c) when an Arrow Fund opens or maintains 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, the Arrow Fund holds:
(i) 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;
(ii) 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 aggregate amount, if any, by which the price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest; or
(iii) a combination of the positions referred to in clauses (i) and (ii) that is sufficient, without recourse to other assets of the Arrow Funds, to enable the Arrow Funds to satisfy its obligations under the future or forward contact; and
(d) an Arrow Fund will not (i) purchase a debt-like security that has an option component or an option, or (ii) purchase or write an option to cover any positions under section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-- 102, if immediately after the purchase or writing of such option, more than 10% of the net assets of the Arrow Fund, taken at market value at the time of the transaction, would be in the form of (1) purchased debt-like securities that have an option component or purchased options, in each case, held by the Fund for purposes other than hedging, or options used to cover any positions under section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-102.
This decision to grant the Cleared Derivatives Relief elements of the Requested Relief will terminate on the coming into force of any revisions to the provisions of NI 81-102 that address the clearing of OTC derivatives.
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Exemplar Leaders Fund
Exemplar Performance Fund
Exemplar Tactical Corporate Bond Fund
Exemplar Investment Grade Fund
Exemplar Growth and Income Fund
Exemplar U.S. High Yield Fund
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