National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- Relief granted from short selling restrictions in National Instrument 81-102 Investment Funds to permit an alternative mutual fund to short sell "government securities", as defined in NI 81-102, up to 300% of net asset value -- relief sought in order to short securities in connection with fund's hedging strategy -- features of government bonds mitigate many of the risks associated with short selling strategies -- relief also granted to future alternative mutual funds managed by the Filer or an affiliate of the Filer with similar short selling strategies.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.6.1(1)(c)(v), 2.6.2, 19.1.
May 29, 2020
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) AND ARROW EC INCOME ADVANTAGE ALTERNATIVE FUND (formerly East Coast Investment Grade Income Fund) (the Initial Fund)
The principal regulator in the Jurisdiction has received an application from the Filer on behalf of the Initial Fund of which the Filer is the investment fund manager, for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) exempting the Initial Fund and any alternative mutual funds for which the Filer or an affiliate of the Filer acts as investment fund manager and which employ short selling strategies similar to the Initial Fund (the Future Funds and together with the Initial Fund, the Funds or individually, a Fund) from the following provisions of National Instrument 81-102 Investment Funds (NI 81-102) in order to permit the Fund to short sell "government securities" as that term is defined in NI 81-102, up to a maximum of 300% of a Fund's net asset value (NAV) (the Exemption Sought):
(a) subparagraph 2.6.1(1)(c)(v) of NI 81-102, which restricts the Funds from selling a security short if, at the time, the aggregate market value of the securities sold short by the Fund exceeds 50% of the Funds' NAV; and
(b) section 2.6.2 of NI 81-102, which states that the Funds may not borrow cash or sell securities short if, immediately after entering into a cash borrowing or short selling transactions, the aggregate value of cash borrowing combined with the aggregate market value of the securities sold short by the Funds would exceed 50% of the Funds' NAV
(collectively, the Short Selling Restrictions).
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, the Other Jurisdictions) (together with the Jurisdiction, the Canadian Jurisdictions).
Terms defined in NI 81-102, National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
This decision is based on the following facts represented by the Filer on behalf of itself and the Funds:
1. The Filer is a corporation existing under the laws of Ontario having its registered head office in Toronto, Ontario.
2. The Filer is the investment fund manager, trustee and portfolio manager of the Initial Fund. The Filer, or an affiliate, will be the investment fund manager and portfolio manager of the Future Funds. The Filer also acts as the investment fund manager and portfolio manager of an investment fund, the East Coast Investment Grade II Fund (ECIG), the securities of which are sold pursuant to exemptions from applicable prospectus requirements in securities legislation.
3. The Filer is registered in the following categories in the jurisdictions as 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.
4. The Filer is not in default of securities legislation in any of the Canadian Jurisdictions.
5. The Funds are or will be open-ended public alternative mutual funds governed by NI 81-102.
6. The Funds are or will be organized as trusts or as part of a mutual fund corporation established under the laws of the Province of Ontario.
7. The Funds will distribute securities in each of the Canadian Jurisdictions pursuant to a simplified prospectus, annual information form and fund facts documents, prepared and filed in accordance with National Instrument 81-101 Mutual Fund Prospectus Disclosure.
8. The Initial Fund is not in default of applicable securities legislation in any of the Canadian Jurisdictions.
9. The Initial Fund began operations on April 26, 2012 and has continuously operated since that date as an exchange-traded closed end investment fund with an investment strategy that includes short selling of government securities.
10. The sub-advisor to the Initial Fund and ECIG is East Coast Fund Management Inc. (the Sub-Advisor). The Sub-Advisor has acted in such capacity since the inception of the Initial Fund and ECIG and will continue to act in such capacity.
11. In a notice of special meeting and management information circular mailed to unitholders of the Initial Fund dated May 13, 2020, the Filer proposed to unitholders of the Initial Fund to restructure the Initial Fund by converting it to an open-end alternative mutual fund from a closed-end investment fund whose units are listed for trading on the Toronto Stock Exchange (the TSX) under the symbol ECF.UN (the Restructuring). It is expected that Unitholders will vote to approve the Restructuring at a special meeting of unitholders to be held on June 12, 2020. As part of the Restructuring the name of the Initial Fund will be changed to Arrow EC Income Advantage Alternative Fund from East Coast Investment Grade Income Fund. It is expected that the units will be de-listed from the TSX as part of the Restructuring.
12. Concurrent with this application, the Initial Fund is filing a simplified prospectus, annual information form and fund facts documents such that the Initial Fund will become an alternative mutual fund to which NI 81-102 applies in that the Initial Fund has fundamental investment objectives that permits it to borrow, sell securities short and invest in specified derivatives in a manner not permitted for non-alternative mutual funds under NI 81-102.
13. The Initial Fund's investment objective is to generate income and preserve capital by investing in a diversified portfolio of primarily North American investment grade corporate bonds. The fund will use leverage. The leverage will be created through the use of cash borrowings, short sales and derivative contracts. The fund's leverage shall not exceed the limits on the use of leverage described in the "Investment Strategies" section in the simplified prospectus or as otherwise permitted under applicable securities legislation.
The Short Hedging Strategy
14. In order to hedge against interest rate risk in the Initial Fund and isolate levered corporate credit exposure, the Initial Fund currently sells short liquid government fixed income securities at the same time that the Initial Fund invests in corporate fixed income securities (the Short Hedging Strategy). The Short Hedging Strategy is effective because there is a high degree of correlation between the movement of government and corporate fixed income securities caused by changes in interest rates, creating a hedge against losses in value of the long corporate position. This relationship is a fundamental part of the fixed-income market such that dealers quote the price of corporate bond based on the incremental yield of the corporate bond over an equivalent term government bond.
15. The Filer believes that the Short Hedging Strategy provides investors with the potential for low volatility and compelling returns. The Short Hedging Strategy has been successful with the Initial Fund since inception as a closed-end investment fund and with ECIG.
16. After the Restructuring, the Short Selling Restrictions would restrict the Initial Fund to short selling government securities to no more than 50% of the Fund's NAV. However, NI 81-102 would otherwise permit the Initial Fund to obtain the additional leveraged short exposure through the use of specified derivatives, up to an aggregate exposure of 300% of the Fund's NAV.
17. The Filer is of the view however, that it would be in the Initial Fund's best interest to permit it to physically short sell government securities, up to 300% of the Fund's NAV, instead of being forced to achieve that degree of leverage through either specified derivatives alone, or a combination of physical short selling and specified derivatives, for the following reasons:
(a) While derivatives can be used to create similar investment exposure as the Short Hedging Strategy up to 300% of the Initial Fund's NAV, the use of derivatives is less effective, is more complex, and is riskier than the Short Hedging Strategy. Derivatives provide credit exposure that is less targeted than the Short Hedging Strategy with a longer duration that increases risk, often without commensurately higher returns. In addition, implementing derivatives necessitates incremental transactional steps. These steps increase both operational risk and counterparty risk, as well as cost.
(b) The risk of covering short government securities positions in a rising market is largely mitigated by several factors: (i) the strong correlation between the government security sold short and the corporate fixed income security held long by the Initial Fund which provides a hedge against short cover risk; (ii) government securities are highly liquid and more than one issuance of government securities can be used to hedge interest rate risk; (iii) government securities have markedly lower price volatility than equity securities; (iv) unlike equity securities, government securities have an effective upper value limit; and (v) financial institutions that facilitate short selling are regulated and implement effective risk controls on short sellers.
(c) The Initial Fund has successfully been short selling government securities as part of a similar Short Hedging Strategy since inception of the Initial Fund.
18. The Future Funds will employ an investment strategy similar to the Short Hedging Strategy in that each will contemplate short-selling government securities concurrently with investing in long positions in corporate fixed income securities.
19. The only securities sold short by the Funds in excess of 50% of a Fund's NAV will be "government securities" as that term is defined in NI 81-102. The Funds will otherwise comply with the provisions governing short selling by an alternative mutual fund under sections 2.6.1 and 2.6.2 of NI 81-102.
20. Each Fund's aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed 300% of the Fund's NAV, in compliance with section 2.9.1 of NI 81-102 (the Aggregate Leverage Limit).
21. The Funds will implement the following controls when conducting a short sale:
(a) the Fund will assume the obligation to return to the Borrowing Agent (as defined in NI 81-102) the securities borrowed to effect the short sale;
(b) the Fund will receive cash for the securities sold short within normal trading settlement periods for the market in which the short sale is effected;
(c) the Filer will monitor the short positions of the Fund at least as frequently as daily;
(d) the security interest provided by the Fund over any of its assets that is required to enable the Fund to effect a short sale transaction is made in accordance with section 6.8.1 of NI 81-102 and will otherwise be in accordance industry practice for that type of transaction and relates only to obligations arising under such short sale transactions;
(e) the Fund will maintain appropriate internal controls regarding short sales, including written policies and procedures for the conduct of short sales, risk management controls and proper books and records; and
(f) the Filer and the Fund will keep proper books and records of short sales and all of its assets deposited with Borrowing Agents as security.
22. Each Fund's prospectus (the Prospectus) will contain adequate disclosure of the Fund's short selling activities, including the material terms of the Exemption Sought.
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 Exemption Sought is granted provided that:
1. The only securities which a Fund will sell short in an amount that exceeds 50% of the Fund's NAV will be securities that meet the definition of "government security" as that term is defined in NI 81-102.
2. Each short sale made by a Fund will otherwise comply with all of the short sale requirements applicable to alternative mutual funds in sections 2.6.1 and 2.6.2 of NI 81-102.
3. A Fund's aggregate exposure to short selling, cash borrowing and specified derivatives will not exceed the Aggregate Leverage Limit.
4. Each short sale will be made consistent with the Fund's investment objectives and investment strategies.
5. The Fund's Prospectus will disclose that the Fund is able to short sell "government securities" (as defined in NI 81-102) in an amount up to 300% of the Fund's NAV, including the material terms of this decision.