IA Clarington Investments Inc.

National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – relief fromcertain specified derivatives and custodial requirements in sections 2.7(1), 2.7(4) and 6.1(1) of National Instrument 81-102 Investment Funds to permit mutual funds to enter into swap transactions that are cleared through a clearing corporation, subject to certain conditions – relief required because of U.S. and European requirements to clear over-the-counter derivatives including swaps – decision treats cleared swaps in a similar way as other cleared derivatives; relief from sections 2.8(1)(d) and 2.8(1)(f)(i) of 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 swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap, subject to certain conditions.

Applicable Legislative Provisions

National Instrument 81-102 Investment Funds, subsections 2.7(1), 2.7(4), 2.8(1)(d), 2.8(1)(f)(i), 6.1(1), and 19.1.

[Translation]

IN THE MATTER OF
THE SECURITIES LEGISLATION OF
QUEBEC AND ONTARIO
(the Jurisdictions)

AND

IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS
IN MULTIPLE JURISDICTIONS

AND

IN THE MATTER OF
IA CLARINGTON INVESTMENTS INC.
(the Filer)

DECISION

Background

The securities regulatory authority or regulator in each of the Jurisdictions (Decision Makers) has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation), pursuant to section 19.1 of Regulation 81-102 respecting Investment Funds CQLR, c. V-1.1, r.39 (Regulation 81-102) exempting the Funds (as defined below), as specified below:

1.             with respect to Cleared Swaps (as defined below):

(a)           from the requirement in section 2.7(1) of Regulation 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,

(b)           from the limitation in section 2.7(4) of Regulation 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 clears and settles transactions made on a futures exchange listed in Appendix A to Regulation 81-102 shall not exceed, for a period of 30 days or more, 10 percent of the net asset value of the mutual fund,

(c)           from the requirement in section 6.1(1) of Regulation 81-102 to hold all portfolio assets of an investment fund under the custodianship of one custodian in order to permit each 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; (collectively, the Cleared Derivatives Relief).

2.             with respect to the derivatives cover requirement:

(a)           from the requirement in sections 2.8(1)(d) and 2.8(1)(f)(i) of Regulation 81-102 in order to permit each of the Funds when it:

(i)            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

(ii)           enters into or maintains a swap position during the periods when the 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 (collectively referred to as the Derivatives 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 dual application):

(a)           the Autorité des marchés financiers is the principal regulator for this application;

(b)           the Filer has provided notice that section 4.7(1) of Regulation 11-102 respecting Passport System CQLR, c. V-1.1, r.1 (Regulation 11-102) is intended to be relied upon in each of the other provinces and territories of Canada other than the Jurisdictions (the Other Jurisdictions); and

(c)           the decision is the decision of the principal regulator and evidences the decision of the securities regulatory authority or regulator in Ontario.

Interpretation

Terms defined in Regulation 14-101 respecting Definitions (CQLR, c. V-1.1, r.3), Regulation 11-102, Regulation 81-101 respecting Mutual Funds Prospectus Disclosure (CQLR, c. V-1.1, r.38) (Regulation 81-101), Regulation 81-102 have the same meaning if used in this decision, unless otherwise defined.

CFTC means the U.S Commodity Futures Trading Commission,

Cleared Swap means any OTC derivative transaction that can be entered into on a cleared basis, whether or not such derivative is subject to a clearing determination or a clearing obligation issued by the CFTC or ESMA,

Clearing Corporation means any clearing agency that acts as a 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 Funds are 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,

Existing Funds means each of the mutual funds managed by the Filer,

Fund or Funds mean the Existing Funds and all future mutual funds managed by the Filer that are subject to Regulation 81-102,

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 of the Funds,

Swaps means the swaps that are, or will become, subject to a clearing determination or clearing obligation issued by the CFTC or ESMA, as the case may be,

Representations

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

1.             The Filer’s head office is in Québec City, Québec.

2.             The Filer is registered as an investment fund manager in Québec, Ontario and Newfoundland and Labrador, as an exempt market dealer in the Jurisdictions, and as a portfolio manager in all of the provinces of Canada.

3.             The Filer is the manager of the Existing Funds. The Portfolio Advisors are, or will be, the sub-advisor to certain of the Funds.

4.             Each 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 Regulation 81-102.

5.             The securities of each 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 Fund is, or will be, a reporting issuer or the equivalent in each of the Jurisdictions.

6.             Neither the Filer nor the Existing Funds are in default of securities legislation in the Jurisdictions or any of the Other Jurisdictions.

Reasons supporting the Cleared Derivatives Relief

7.             The investment objective and investment strategies of each Fund that enters into, or will enter into, Cleared Swaps permit, or will permit the Funds to enter into derivative transactions, including Cleared Swaps.

8.             Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a Clearing Corporation.

9.             EMIR also requires that certain OTC derivatives be cleared through a central counterparty authorized to provide clearing services for purposes of EMIR.

10.          In addition to clearing swaps that are mandated to be cleared under Dodd-Frank and/or EMIR, many of the Clearing Corporations offer clearing services in respect of other types of derivative transactions. Many global derivative end-users enter into Cleared Swaps on both a voluntary and a mandatory basis.

11.          In absence of the Cleared Derivatives Relief, each Portfolio Advisor will need to structure the derivative transactions entered into by the applicable Funds so as to avoid clearing, including 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 Funds and their securityholders for a number of reasons, as set out below.

12.          The Filer wishes that the Funds have the ability to enter into Cleared Swaps in order to benefit from the pricing benefits and reduced trading costs that each Portfolio Advisor is often able to achieve through its trade execution practices and from the reduced costs associated with Cleared Swaps as compared to OTC trades.

13.          A Portfolio Advisor may use common trade execution practices for all of its accounts, including the Funds. If these practices involve the use of Cleared Swaps and if the Funds are unable to employ these trade execution practices, then the Portfolio Advisor would have to create separate trade execution practices only for the Funds and would have to execute trade for the Funds on a separate basis. This would increase the operational risk for the Funds and would prevent the Funds from benefitting from the pricing benefits and reduced trading costs that a Portfolio Advisor may be able to achieve through common practices for its advised accounts. 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 Cleared Swaps.

14.          In accordance with the Filer’s standard of care owed to the Funds pursuant to applicable legislation, the Filer has determined that central clearing represents the best choice for the securityholders of the Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.

15.          As a member of the G20 and a participant in the September 2009 commitment of G20 nations to improve transparency and mitigate risk in derivatives markets, Canada has expressly recognized the systemic benefits that clearing OTC derivatives offers to market participants, such as the Funds. The Filer respectfully submits that the Funds should be encouraged to comply with the robust clearing requirements established by the CFTC and under EMIR by granting them the Cleared Derivatives Relief.

16.          The Cleared Derivatives Relief is analogous to the treatment currently afforded under Regulation 81-102 to other types of derivatives that are cleared, i.e., clearing corporation options, options on futures and standardized futures. This demonstrates that, from a policy perspective, such Cleared Derivatives Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.

Reasons Supporting the Derivatives Cover Relief

17.          Paragraph 2.8(1)(d) and subparagraph 2.8(1)(f)(i) of Regulation 81-102 do not permit covering a long position in a standardized future or forward contract or a position in a swap for a period when a mutual 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. Accordingly, these provisions of Regulation 81-102 do not permit the use of put options or short future, forward or swap positions to cover long future, forward or swap positions.

18.          By not recognizing the hedging properties of options for long positions evidenced by standardized futures or forwards or in respect of swaps where a mutual fund is entitled to receive payments from the counterparty, Regulation 81-102 effectively imposes the requirement to over-collateralize, since the maximum liability to the mutual fund under this scenario is equal to the difference between the market value of the long position and the exercise price of the option. Overcollateralization imposes a cost on a mutual fund.

19.          Paragraph 2.8(1)(c) of Regulation 81-102 permits a mutual fund to write a put option and cover it with buying a right or obligation to sell an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a debt-like security that has a component that has a long position in a forward or a standardized future or forward contract as contemplated by paragraph 2.8(1)(d) or a swap as contemplated by subparagraph 2.8(1)(f)(i) and therefore, the Filer submits that the Funds should be permitted to cover a long position in a future, forward or swap with a put option or an offsetting short position.

20.          The Filer submits that the Derivatives Cover Relief would enable the Funds to more effectively manage any exposure they may have under specified derivatives and to have the flexibility to enhance yield.

21.          For the reasons provided above, the Filer submits that it would not be detrimental to the protection of investors to grant the Requested Relief to the Funds.

Decision

Each of the Decision Makers is satisfied that the decision meets the test set out in the Legislation for the Decision Maker to make the decision.

The decision of the Decision Makers under the Legislation is that the Requested Relief are granted provided that:

1.             In the case of the Cleared Derivatives Relief, the Clearing Corporation is permitted to offer customer clearing of OTC derivatives in the jurisdiction of Canada where the applicable Fund is located and provided further that, in respect of the deposit of cash and other portfolio assets as margin:

(a)           In Canada,

(i)            The Futures Commission Merchant is a member of a SRO that is a participating member of CIPF; and

(ii)           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% of the net asset value of the Fund as at the time of deposit; and

(b)           Outside of Canada,

(i)            The Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to regulatory audit;

(ii)           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

(iii)           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% of the net asset value of the Fund as at the time of deposit;

2.             In the case of the Derivatives Cover Relief:

(a)           When a Fund enters into or maintains a swap position for periods when the Fund would be entitled to receive fixed payments under the swap, the 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 Fund under the swap less the obligations of the 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 Fund, to enable the Fund to satisfy its obligations under the swap;

(b)           When a 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 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 Fund, to enable the Fund to satisfy its obligations under the future or forward contract; and

(c)           A 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 paragraphs 2.8(1)(b), (c), (d), (e) and (f) of Regulation 81-102, if immediately after the purchase or writing of such option, more than 10% of the net asset value of the 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 (2) options used to cover any positions under paragraphs 2.8(1)(b), (c), (d), (e) and (f) of Regulation 81-102;

This decision to grant the Cleared Derivatives Relief will terminate on the coming into force of any revisions to the provisions of Regulation 81-102 that address the clearing of OTC derivatives.

Hugo Lacroix,
Senior Director, Investment Funds
Autorité des marchés financiers