National Instrument 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- Relief to permit a senior loan exchange-traded fund to borrow cash up to an amount equal to 10% of NAV as a temporary measure to accommodate requests for the redemption of units of the fund -- relief needed due to longer settlement times of senior loans -- relief subject to numerous conditions -- National Instrument 81-102 Investment Funds.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, subparagraph 2.6(a)(i) and section 19.1.
March 19, 2018
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 FRANKLIN TEMPLETON INVESTMENTS CORP. (the Filer)
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Franklin Liberty Senior Loan ETF (CAD-Hedged) (the Franklin ETF) for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) for relief, pursuant to Section 19.1 of National Instrument 81-102 -- Investment Funds (NI 81-102), from the borrowing restriction in Section 2.6(a)(i) of NI 81-102, in order to allow the Franklin ETF to borrow cash on a temporary basis to accommodate requests for the redemption of its Units (as defined below) while the Franklin ETF settles portfolio transactions initiated to satisfy such redemption requests provided that the outstanding amount of all borrowings of the Franklin ETF does not exceed 10% of its net asset value at the time of borrowing (the Exemption Sought).
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 section 4.7(1) of Multilateral Instrument 11-102 -- Passport System (MI 11-102) is intended to be relied upon in each province and territory of Canada other than the Jurisdiction (including Ontario, the Jurisdictions).
Terms defined in National Instrument 14-101 -- Definitions (NI 14-101), MI 11-102 or NI 81-102 have the same meaning if used in this decision, unless otherwise defined herein.
"Basket of Securities" means a group of securities determined by the Filer from time to time representing the constituents of the investment portfolio then held by the Franklin ETF.
"Dealers" means registered brokers and dealers that will enter into dealer agreements with the Franklin ETF and that will subscribe for and purchase Units of the Franklin ETF, and "Dealer" means any one of them.
"Designated Broker" means a registered broker or dealer that will enter into an agreement with the Filer in respect of the Franklin ETF to perform certain duties in relation to the Franklin ETF, including posting a liquid two-way market for the trading of Units on the TSX or another marketplace.
"Designated Counterparty" means a person or company, or the direct or indirect parent company of such person or company, whose securities have a "designated rating", as defined in National Instrument 44-101 -- Short Form Prospectus Distributions.
"Prescribed Number of Units" means the number of Units of the Franklin ETF determined by the Filer from time to time for the purpose of subscription orders, exchanges, redemptions or for other purposes.
"Unit" means a redeemable, transferable unit of the Franklin ETF, which represents an equal, undivided interest in the net assets of the Franklin ETF and "Units" means more than one Unit.
"Unitholders" means beneficial and registered holders of Units of the Franklin ETF.
This decision is based on the following facts represented by the Filer on behalf of itself and the Franklin ETF:
1. The Filer is a corporation amalgamated under the laws of the Province of Ontario, with its head office located at 200 King Street West, Suite 1500, Toronto, Ontario.
2. The Filer is registered as an investment fund manager in Ontario, Québec, Alberta, British Columbia, Manitoba, Nova Scotia, and Newfoundland and Labrador, as a mutual fund dealer, portfolio manager and exempt market dealer in each province of Canada and the Yukon, and as a commodity trading manager in Ontario.
3. The Filer will be the trustee and manager of the Franklin ETF.
4. Franklin Advisers Inc. will be retained to provide all portfolio management services in respect of the Franklin ETF (the Portfolio Advisor) pursuant to the international advisor exemption in section 8.26 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations. The Portfolio Advisor is a registered investment advisor with the U.S. Securities and Exchange Commission (SEC) and has offices based in San Mateo, California and is an affiliate of the Filer.
5. The Filer is not in default of securities legislation in any of the Jurisdictions.
The Franklin ETF
6. The Franklin ETF will be a reporting issuer in the Jurisdictions. The Franklin ETF will distribute Units in such jurisdictions pursuant to a long form prospectus prepared pursuant to Form 41-101F2 Information Required in an Investment Fund Prospectus (the Prospectus).
7. The Franklin ETF will be an exchange traded mutual fund in continuous distribution that is subject to NI 81-102.
8. The Franklin ETF will issue Units that will be listed and posted for trading on the Toronto Stock Exchange (the TSX).
9. The investment objective of the Franklin ETF will be to seek to provide a high level of current income while preserving capital by investing primarily in senior-secured income-producing floating rate corporate loans made to, and corporate debt securities issued by, U.S. and non-U.S. entities. The Franklin ETF will normally invest between 80-95% of its net assets in income-producing floating rate corporate loans made to, and corporate debt securities issued by, U.S. and non-U.S. entities. The Franklin ETF will invest, under normal market conditions, at least 75% of its net assets in floating rate investments that are rated B or higher at the time of purchase by a nationally recognized statistical rating organization (an NRSRO) or, if unrated, are determined to be of comparable quality by the Portfolio Advisor. It may also, under normal market conditions, invest up to 25% of its net assets in floating rate investments that are rated below B by an NRSRO or, if unrated, are determined to be of comparable quality by the Portfolio Advisor. The Franklin ETF generally expects to invest a portion of its assets in cash, cash equivalents and high quality money market securities, including commercial paper, repurchase agreements and affiliated or unaffiliated money market funds, to manage liquidity and while seeking investment opportunities.
10. The Filer anticipates that the senior loans in which the Franklin ETF will invest will have a settlement cycle that may be longer than two business days.
11. Currently, approximately 5-10% of the Franklin ETF's portfolio will be comprised of cash and/or securities that will settle within two business days. The Filer plans to continue this practice for the medium term, but has the discretion to adjust this weighting at any time.
12. The Franklin ETF invests in senior loans that the Portfolio Advisor believes exhibit the best combination of attractive fundamental credit characteristics and relative value within the senior loan market. The Portfolio Advisor seeks to assemble a well-diversified portfolio that includes loans of issuers with strong credit metrics, including strong cash flows and effective management teams. Senior loans, compared to equivalently rated unsecured high yield bonds, typically offer a higher recovery rate because of the protection offered by their secured nature and their priority claim relative to other debt instruments.
13. Recognizing the longer settlement time for senior loans, the strategy will utilize the cash allocation within the portfolio to help manage liquidity needs. In addition, the strategy by design focuses on the larger issuers in the market which also tend to have better liquidity characteristics.
14. The Portfolio Advisor has access to quotations with bid-ask spreads from the major broker-dealers active in the senior loan market, which will allow the Portfolio Advisor to monitor and assess the liquidity of the portfolio assets and the market as a whole. The Portfolio Advisor will actively monitor the earnings reports, price movements, and bid-ask spreads of the Franklin ETF's portfolio as part of its active management, and the Portfolio Advisor will monitor compliance to the investment strategy in real-time. The Franklin ETF's portfolio of senior loans will be actively monitored by the Portfolio Advisor, and the Portfolio Advisor will process all information available to it as part of its daily portfolio management activities.
15. In addition to the ongoing monitoring of the markets and the Franklin ETF portfolio assets described above, each individual investment will go through a fundamental credit analysis (qualitative and quantitative), which will include an analysis of the possible downside of the investment, which may be referred to as a stress test, before actual investment by the Franklin ETF. This analysis will include, amongst other things:
(a) revenue/EBITDA projections and sensitivity analysis including break-even point;
(b) margin projections and sensitivity analysis;
(c) impact of interest rates on cash flows;
(d) free cash flow analysis; and
(e) any other specific analysis appropriate for a particular sector and/or investment.
16. Because they are secured against specific collateral of the borrower, senior loans offer a higher likelihood of recovery in the event of a borrower default compared to equivalently rated unsecured high yield bonds. In addition, senior loans have a higher priority claim relative to other debt instruments, increasing the chances of recovery in the event of bankruptcy or reorganization.
17. The purchaser of a senior loan that will be transacting with the Franklin ETF will always be a dealer that is a Designated Counterparty.
18. The vast majority of sales of senior loans between the Franklin ETF and a Designated Counterparty will be subject to the standard terms and conditions for par / near par trade confirmations published by the Loan Syndications and Trading Association (the Terms), which Terms are binding on the parties to the transaction and do not contain any "outs" for force majeure or the stress or dislocation of the senior loan market (the foregoing does not apply in the rare case of a distressed loan).
19. During any Drawdown Period, the purchaser that will be interacting with the Franklin ETF with respect to a senior loan will always be a dealer that is a Designated Counterparty.
20. When selecting senior loans for the Franklin ETF, the Portfolio Advisor will use fundamental analysis to evaluate the investment opportunities of each issuer. When monitoring the risk associated with portfolio investments, the Portfolio Advisor will consider whether the Franklin ETF is over or under represented in a specific industry sector. The Franklin ETF's loans will typically be held until maturity, but may be sold if attractive opportunities arise.
21. Generally, orders to purchase Units directly from the Franklin ETF will be placed by the Designated Broker or a Dealer in a Prescribed Number of Units (or an integral multiple thereof). Investors are generally expected to purchase and sell Units, directly or indirectly, through dealers executing trades through the facilities of the TSX or another marketplace in Canada. Units may also be issued directly to the Franklin ETF's investors upon the reinvestment of distributions of income or capital gains.
22. Unitholders may redeem Units of the Franklin ETF for cash at a redemption price per Unit equal to 95% of the closing price for the Units on the TSX on the effective day of the redemption, subject to a maximum redemption price of the net asset value per Unit. Unitholders of the Franklin ETF (generally the Designated Broker or the Dealers) may also exchange the Prescribed Number of Units (or an integral multiple thereof) for Baskets of Securities and/or cash in the discretion of the Filer.
23. The net asset value per Unit of each series of the Franklin ETF will be calculated and published on any day where there is a trading session on the TSX or other marketplace and will be made available on the Filer's website at www.franklintempleton.ca.
24. The Franklin ETF is expected to make monthly distributions of income. If monthly distributions are made, such distributions would be funded through the net assets of the Franklin ETF and not through borrowings; however, the year-end distribution may be funded through net assets and/or borrowing in compliance with the exemption granted to the Filer dated April 18, 2017, provided that the outstanding amount of all borrowing of the Franklin ETF does not exceed 10% of its net asset value at the time of borrowing.
25. The Filer believes the senior loan investments that will be made by the Franklin ETF will be able to be liquidated in a timely fashion, given the size and depth of the overall senior loan market. However, the settlement time for such securities is typically longer than that of equity securities.
26. The Filer has determined that it would be prudent for the Franklin ETF to request the Exemption Sought in order to borrow cash on a temporary basis to accommodate requests for the exchange or redemption of its Units while the Franklin ETF settles portfolio transactions initiated to satisfy such requests provided that the outstanding amount of all borrowing of the Franklin ETF does not exceed 10% of its net asset value at the time of borrowing.
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 Decision Maker under the Legislation is that the Exemption Sought is granted provided that:
(a) if trading of the Units on the TSX of the Franklin ETF is suspended for a period exceeding 30 days, the Franklin ETF will begin taking all necessary steps to ensure that all amounts borrowed under the overdraft facility are fully repaid as soon as commercially reasonable, but no later than 90 days from the date of suspension, provided that such repayment need not be completed if the suspension is lifted within 90 days from the date of the suspension;
(b) the Franklin ETF will not make a distribution to its Unitholders where that distribution would impair the ability of the Franklin ETF to repay the funds borrowed under the overdraft facility;
(c) the Franklin ETF will have text box disclosure in each prospectus and ETF Facts filed in connection with the continuous distribution of Units, stating that (i) the Franklin ETF invests primarily in senior loans, which are generally rated below investment grade debt; (ii) settlement periods for senior loans may be longer than for other types of debt securities such as corporate bonds; and (iii) investing in the Franklin ETF is not a substitute for holding cash or money market securities;
(d) the Franklin ETF will disclose, in each prospectus filed in connection with the continuous distribution of Units, the maximum percentage of assets of the Franklin ETF the borrowing may represent, the Franklin ETF's intended use of the amounts borrowed, the material terms of any credit facility that may be used by the Franklin ETF and the risks arising from the borrowing; and
(e) the Franklin ETF may only borrow cash in excess of 5% of its net asset value if all of the following conditions are satisfied:
(i) after giving effect to the borrowing, the outstanding amount of all borrowings of the Franklin ETF does not exceed 10% of its the net asset value of the Franklin ETF;
(ii) the Franklin ETF has entered into a fully binding agreement with a Designated Counterparty(s) to sell a senior loan(s) in order to satisfy redemption requests, but the settlement period on the senior loan(s) exceeds two days;
(iii) the amount of cash that the Franklin ETF borrows does not exceed the amount of cash that it will receive in respect of the sale of the senior loan(s) referred to in paragraph (e)(ii) above; and
(iv) the Franklin ETF has sold all of the securities in its portfolio, other than senior loan holdings, and has used all of its available cash in order to satisfy redemption requests.