Securities Law & Instruments


Headnote

NP 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – Exemptive relief granted to permit non-redeemable investment funds to enter a position in a specified derivative the underlying interest of which is a security of the investment fund, relief subject to certain conditions – National Instrument 81-102 Investment Funds.

Applicable Legislative Provisions

National Instrument 81-102 Investment Funds, ss. 9.1.1(b), 19.1.

October 5, 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
PURPOSE INVESTMENTS INC.
(THE FILER)

AND

IN THE MATTER OF
INVESTMENT GRADE MANAGED DURATION INCOME FUND,
U.S. BANKS INCOME & GROWTH FUND
(THE EXISTING FUNDS)

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 (the Legislation) pursuant to section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102) exempting each Existing Fund and each additional non-redeemable investment fund of which the Filer becomes the manager in the future (each a Future Fund and, together with the Existing Funds, the Funds) from subsection 9.1.1(b) of NI 81-102 to permit each Fund to enter in a Derivative (as defined below) (the Requested Relief).

Under National Policy 11-203 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 pursuant to section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) that the Requested Relief is intended to be relied upon in each province and territory of Canada.

Interpretation

Defined terms contained in National Instrument 14-101 Definitions and MI 11-102 have the same meaning in this decision unless they are otherwise defined in this decision.

All representations made in respect of a Future Fund are represented as being true at the time the Future Fund relies upon the Requested Relief.

Representations

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

The Filer

1.             The Filer is a corporation incorporated under the laws of the Province of Ontario with its head office located in Toronto, Ontario. The Filer is registered under the securities legislation of Ontario as an investment fund manager, portfolio manager and exempt market dealer. The Filer is not in default of securities legislation in any province or territory of Canada.

2.             The Filer is the manager of each Fund.

The Funds

3.             Each Fund is a trust governed by a declaration of trust under the laws of the Province of Ontario (a Declaration of Trust). Each Fund is a reporting issuer (or the equivalent) under the securities legislation of the Jurisdiction. Each Fund is a non-redeemable investment fund. A class of units (the Units) of each Fund is posted for trading on the Toronto Stock Exchange (the TSX).

4.             Each Fund is not in default of securities legislation in any province or territory of Canada.

5.             Each Fund uses the unit traded fund (UTF) structure which has been developed to accomplish two goals, namely:

(a)           to enable the Fund to invest virtually all of the gross proceeds from each public offering (an Offering) of its securities in its investment portfolio (a Portfolio); and

(b)           to encourage the Fund’s Units to trade in the market at a price not less than 98.50% of their net asset value per unit (the NAVPU) throughout the life of the Fund.

6.             Using the UTF structure, each Fund is not responsible for paying any of the compensation to the registered dealers that sell securities of the Fund in an Offering, and the Fund does not bear expenses relating to any Offering of more than 0.50% of the gross proceeds from such Offering. As a result, the NAVPU immediately after the closing of an Offering is not less than 99.5% of the issue price under the Offering. All other Offering expenses (including the commissions payable to registered dealers) are borne by National Bank Financial Inc. as part of the services it provides to the Fund under an agreement.

7.             The UTF structure also includes a mandatory market purchase program under which each Fund purchases and cancels Units which are offered in the market at 98.50% or less of their most recently calculated NAVPU (up to a maximum of 10% of the outstanding Units over any 10 trading day period, subject to a limit of 2% of the number of Units outstanding each trading day and subject to the terms set out in its Declaration of Trust). This is in addition to an annual right of Unitholders of each Fund to redeem their Units at a price of 100% of their NAVPU (the Annual Redemption Right), commencing three years after the completion of the Fund’s initial public offering.

Proposed Market Maker Arrangement

8.             The Filer believes that it would be advantageous for the unitholders of the Funds if each Fund enters into an arrangement (the Market Maker Arrangement) with an investment dealer (the Market Maker) pursuant to which the Market Maker would trade in Units of the Fund with the objective of maintaining the trading price for the Units within 0.50% of their Estimated Real Time NAVPU (as defined below) (the Target Spread).

9.             The Estimated Real Time NAVPU will be computed by the Market Maker either by:

(a)           revaluing the Portfolio of the Fund most recently publicly disclosed by the Filer using the current, publicly disclosed trading prices for the securities in the Portfolio (the Portfolio Revaluation Approach); or

(b)           revaluing the most recently calculated and publicly disclosed NAVPU of the Fund by multiplying it by a market factor (such as an index) that the Filer believes is highly correlated with changes in the NAVPU (the Proxy Revaluation Approach).

Generally, the Portfolio Revaluation Approach will be used as long as the Fund publicly discloses its Portfolio on a daily basis.

10.          The Filer believes that the Market Maker Arrangement will operate more effectively using an Estimated Real Time NAVPU rather than the most recently calculated NAVPU of a Fund since the Estimated Real Time NAVPU will reduce the effects of changes in the value of the positions in the Fund’s investment portfolio during the current day.

11.          Under the Market Maker Arrangement, the Market Maker generally will purchase Units of a Fund over the TSX or other exchange when offered at a price that is 99.5% or less of their Estimated Real Time NAVPU to a maximum of 10% of the outstanding Units of the Fund. In the ordinary course, the Market Maker then will hold such Units (the Market Maker Holdings) until either:

(a)           the trading price for the Units is 100.5% (or more) of their Estimated Real Time NAVPU, in which event the Market Maker will sell the Units over the TSX or other exchange from the Market Maker Holdings; or

(b)           the Market Maker redeems the Units in the Market Maker Holdings using the Fund’s Annual Redemption Right.

12.          The Market Maker Arrangement is similar to equivalent trading activity by investment dealers in securities of exchange-traded funds (ETFs) in Canada that generally has the effect of maintaining the trading price of such securities within a narrow trading band of their net asset value per security. However, the following differences exist between such trading activity and the Market Maker Arrangement:

(a)           ETFs are mutual funds that provide their securityholders with the right to redeem their securities daily based on their net asset value per security. When an investment dealer purchases securities of the ETF over the TSX or other exchange at a discount to their net asset value per security, the investment dealer is able to redeem a prescribed number of such securities on any business day at their net asset value per security. By comparison, each Fund is a non-redeemable investment fund that provides the Annual Redemption Right only once each year, commencing three years after the completion of its initial public offering.

(b)           Securities of an ETF are in continuous distribution under a long-form prospectus. When securities in the ETF are trading over the TSX or other exchange at a premium to their net asset value per security, an investment dealer can purchase those securities under the ETF’s prospectus at their net asset value per security and resell such securities over the TSX or other exchange at a premium to their net asset value per security. By comparison, Units of each Fund are not in continuous distribution and any sale of Units by the Market Maker must be from the Market Maker Holdings.

(c)           The investment objectives and strategies of an ETF typically involve passive portfolio management designed to replicate the performance of a benchmark, index, commodity price or static portfolio of securities. Such passive management and transparency of portfolio exposure enables an investment dealer that holds securities of the ETF to identify and hold financial instruments that can hedge the investment dealer’s exposure to changes in the net asset value per security of the ETF while the investment dealer holds those securities. By comparison, the Portfolio of each Fund is comprised of multiple investments that are actively managed in accordance with the Fund’s investment objectives, strategies and restrictions. This results in the performance of the Fund’s Portfolio - and consequent changes to its NAVPU – not being highly correlated with any particular benchmark, index or market price with the result that there is no financial instrument that can provide the Market Maker with a hedge of its exposure to changes in the NAVPU of the Fund while its Units are held in the Market Maker Holdings.

13.          The ability of the Market Maker to hedge its exposure to changes in the NAVPU of a Fund while its Units are held in the Market Maker Holdings is a prerequisite to the Market Maker Arrangement. In order to provide the Market Maker with the opportunity for such a hedge, the Filer proposes that each Fund enter into a specified derivative with the Market Maker (a Derivative) for which Units of the Fund will be the underlying interest. The Derivative is expected to take the form of either a swap or a forward agreement. The Derivative will permit the Market Maker to increase or reduce the number of Units of a Fund (the Notional Units) that are the underlying interest of its Derivative. The Filer expects that the Market Maker generally will:

(a)           increase the number of Notional Units of a Fund under its Derivative each day (an Upsize Date) by the number of actual Units of the Fund purchased by the Market Maker that day; and

(b)           decrease the number of Notional Units of a Fund under its Derivative each day (a Downsize Date) by the number of actual Units of the Fund sold or redeemed by the Market Maker that day.

The Derivative also will permit the Fund to partially settle the Derivative from time to time in order to manage the Fund’s exposure thereunder, in which event the Fund will retract an equivalent number of Units from the Market Maker Holdings at their NAVPU.

14.          The arrangement described in paragraph 13 above will be established to permit the Market Maker to change the number of Notional Units that are the underlying interest of the Derivative based on the actual number of Units held by the Market Maker at any time in order to provide the Market Maker with a hedge against changes in the value of the Units in the Market Maker Holdings.

15.          Under the terms of each Derivative, on each Downsize Date for a Fund:

(a)           the Fund will pay to the Market Maker an amount (the Fixed Amount) for each Notional Unit by which its Derivative is reduced equal to the lesser of:

(i)            the Estimated Real Time NAVPU at the time an actual Unit of the Fund was purchased by the Market Maker less 0.25%; and

(ii)           the price at which at which an actual Unit of the Fund was purchased by the Market Maker plus 0.25%;

(b)           the Market Maker will pay to the Fund for each Notional Unit by which its Derivative is reduced a variable amount (the Floating Amount) equal to either:

(i)            if an actual Unit of the Fund was sold by the Market Maker, the greater of:

(A)           the Estimated Real Time NAVPU at the time of such sale plus 0.25%; and

(B)           the price at which the actual Unit of the Fund was sold by the Market Maker less 0.25%; or

(ii)           if an actual Unit of the Fund in the Market Maker Holdings was redeemed or retracted, the NAVPU at which such Unit was redeemed or retracted; and

(c)           the Fixed Amount and the Floating Amount will be netted against each other such that (i) the Fund will pay the difference between the two amounts if the Fixed Amount is higher than the Floating Amount, and (ii) the Market Maker will pay the difference between the two amounts if the Floating Amount is higher than the Fixed Amount.

Where Notional Units of a Fund have been added to its Derivative on more than one Upsize Date, the Fixed Amount will be calculated as the weighted average of all Fixed Amounts under such Derivative.

16.          The arrangement described in paragraph 15 above, not accounting for the Funding Fee (as defined below) and changes to the Derivative Spread (as defined below) between each Upsize Date and Downsize Date, will effectively require that the Market Maker pay to the Fund any increase in the NAVPU between the Upsize Date and the Downsize Date and will effectively require that the Fund pay to the Market Maker any decrease in the NAVPU between the Upsize Date and Downsize Date. As a result, the Fund can be viewed as having a long position in Units under the Derivative while the Market Maker can be viewed as having a short position in Units under the Derivative.

17.          On each Upsize Date and Downsize Date, the Market Maker will provide a report (the Derivative Report) to the Filer that details the changes to the number of Notional Units under the Derivative, including the Fixed Amount and Floating Amount. The report also will include the Estimated Real Time NAVPU at the time of each purchase or sale of Units of the Fund by the Market Maker.

18.          The Derivative will contain a procedure (the Derivative Correction Procedure) whereby the Filer can give notice to the Market Maker of an error in the Derivative Report and, if the Market Maker and the Filer are unable to agree on the correction to be made to the Derivative Report, the disagreement is referred to the binding determination of a third party.

19.          On each Upsize Date for a Fund, the Fund will set aside cash cover equal to the increase to the Fixed Amount for the Notional Units added to its Derivative.

20.          The Fund’s returns under its Derivative will correlate to the changes in its NAVPU between the Upsize Date and the Downsize Date, and will be slightly more positive (or less negative) than the Fund’s actual changes in its NAVPU during that period due to:

(a)           the Fixed Amount being at least 0.25% lower than the Estimated Real Time NAVPU on the Upsize Date; and

(b)           the Floating Amount being equal to or greater than the Estimated NAVPU on the Downsize Date.

21.          The Fixed Amount can be viewed as the sum of two components, namely:

(a)           the Estimated Real Time NAVPU at the time of purchase; and

(b)           a portion of the difference between the trading price of its Units on the TSX and their Estimated Real Time NAVPU at the time of purchase, with a minimum portion for purposes of the Derivative of (0.25%), (Derivative Spread).

22.          Similarly, the Floating Amount can be viewed as the sum of two components, namely:

(a)           the Estimated Real Time NAVPU at the time of sale; and

(b)           a portion of the difference between the trading price of its Units on the TSX and their Estimated Real Time NAVPU at the time of sale, with such portion never being a negative amount for purposes of the Derivative (also Derivative Spread).

23.          Accordingly, the Fund’s returns under its Derivative can be viewed as the sum of:

(a)           the change in its Estimated Real Time NAVPU between the Upsize Date and the Downsize Date under its Derivative; and

(b)           the change in Derivative Spread between the Upsize Date and the Downsize Date under its Derivative.

24.          Since, in the ordinary course, the Market Maker will:

(a)           purchase actual Units and add Notional Units to a Fund’s Derivative when its Derivative Spread is at least (0.25)%; and

(b)           sell actual Units and reduce Notional Units from a Fund’s Derivative when its Derivative Spread is at least 0.25%, and otherwise redeem actual Units resulting in a Derivative Spread of nil,

the Filer expects that each Fund’s returns under its Derivative from changes in its Derivative Spread always will be positive (also Accretion). Since the remainder of each Fund’s returns under its Derivative will be determined by the changes in its Estimated Real Time NAVPU between each Upsize Date and Downsize Date, each Fund’s overall returns under its Derivative will be highly correlated with the changes in its NAVPU during the term of its Derivative.

25.          Under each Fund’s Derivative, the Market Maker will receive a fee (the Funding Fee) calculated as a percentage of the notional amount of the Derivative. The Filer anticipates that each Fund will receive interest on its cash cover that will partially offset the Funding Fee which the Fund pays under its Derivative. The Filer expects that the balance of the Funding Fee will be offset by Accretion. Accordingly, the Filer does not anticipate any Derivative being a net expense to the Fund. The Filer also does not expect any Fund to profit materially from Accretion after paying its Funding Fees, and no Fund will be entering into its Derivative for the purpose of seeking such a profit.

26.          The Filer also expects that the Market Maker will make a small trading profit equal to:

(a)           the amount by which the price at which an actual Unit is purchased by the Market Maker is less than the Fixed Amount calculated for a Notional Unit as described in paragraph 15(a) above; and

(b)           the amount by which the price at which an actual Unit is sold by the Market Maker exceeds the Floating Amount calculated for a Notional Unit as described in paragraph 15(b) above,

in each case not exceeding 0.25% of the Estimated Real Time NAVPU at the time of the purchase or sale.

27.          Each Derivative will be a total return instrument in that:

(a)           it will include adjustments for any distributions paid by the Fund for the number of Notional Units under the Derivative (Notional Distributions); and

(b)           the Market Maker will be required to pay to the Fund an amount equal to the Notional Distributions within 90 days after the distribution is paid by the Fund.

28.          The Market Maker does not have a financial incentive to purchase actual Units at a trading price less than 99.50% of the Estimated Real Time NAVPU or sell actual Units at a trading price greater than 100.50% of the Estimated Real Time NAVPU since the Market Maker’s compensation from the Market Making Arrangement is effectively capped at 0.25% of the trading price of the Units at the time they are purchased and sold due to the manner in which the Fixed Amount and Floating Amount are calculated. Though the Market Maker’s compensation from the Market Maker Arrangement would be lessened or nil if Units were purchased or sold at trading prices within the Target Spread, the Filer is not seeking the Market Maker to be making such purchases or sales when the trading price for the Units is within the Target Spread.

29.          The Fund does not intend to issue any Units to the Market Maker under the Market Making Arrangement. Any Units redeemed or retracted from the Market Maker Holdings will be at a price equal to their NAVPU. When a payment under the Derivative coincides with a redemption or retraction of Units from the Market Maker Holdings, the redemption or retraction proceeds payable by the Fund and the amount payable or receivable by the Fund under the Derivative at that time may be aggregated together and result in the Fund paying a net amount to the Market Maker which is either less than the NAVPU (if the Fund’s performance has been positive) or more than the NAVPU (if the Fund’s performance has been negative). This will not result in an accretive or dilutive effect on the NAVPU since changes to the NAVPU will be the result of the Fund’s performance rather than the prices at which Units are redeemed or retracted from the Market Maker Holdings.

30.          The Funding Fee paid by each Fund will be included in its trading expense ratio. Each management report of fund performance (MRFP) of a Fund will include a brief discussion of the net costs and net benefits to the Fund of the Derivative during the period covered by the MRFP.

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:

(a)           the Filer does not provide the Market Maker with any information regarding any Fund’s Portfolio that is not available to the public;

(b)           the Derivative may be terminated by each Fund unilaterally upon notice by the Fund to the Market Maker;

(c)           the Derivative is valued daily as the difference between the Floating Amount and the Fixed Amount and the Floating Amount is marked to market daily to the closing trading price of the Fund’s Units;

(d)           the total number of Notional Units under all Derivatives of a Fund does not exceed 10% of the total number of Units of the Fund then outstanding;

(e)           when calculating the Estimated Real Time NAVPU, the Market Maker uses the same valuation principles as are used by the Fund to value its Portfolio;

(f)            on each Upsize Date and Downsize Date of a Fund, the Filer reviews the Derivative Report provided by the Market Maker and utilizes the Derivative Correction Procedure where the Filer believes the Derivative Report contains an error (including an error in the calculation of the Estimated Real Time NAVPU); and

(g)           upon a redemption or retraction of Units from the Market Maker Holdings, the Market Maker will be entitled to receive the NAVPU for each Unit so redeemed or retracted.

“Raymond Chan”
Manager,
Investment Funds and Structured Products Branch
Ontario Securities Commission