Fund managers must ensure that assets posted as collateral in derivatives transactions are only held as collateral, and are not sold, regulators have ruled.
According to the April 2015 issue of the Investment Funds Practitioner, which is issued by the Investment Funds and Structured Products branch of the Ontario Securities Commission (OSC), regulators have been asked for an opinion on the question of whether assets that are posted as collateral by an investment fund in an over-the-counter (OTC) derivatives transaction can be rehypothecated (pledged, sold or otherwise encumbered) by the counterparty that accepts the collateral. The report indicates that OSC staff have concluded that “rehypothecation of collateral deposited by an investment fund with a counterparty is generally not permitted” under mutual fund rules.
It notes that the fact that portfolio assets can be used as collateral in derivatives transactions represents an exception from the requirement that all of a fund’s assets must be held by its custodian. And, given that virtually all of a fund’s assets could be posted as collateral, if a counterparty were to rehypothecate those assets, this would expose the funds to excess risks.
“Given this interpretation, we remind fund managers of their responsibility to ensure that any agreement documenting the OTC derivatives transaction prohibits the counterparty from using the collateral,” it says. And, it says that fund managers must ensure that the documentation accompanying a derivatives transaction, “adequately protects the investment fund’s portfolio assets from counterparty credit risk”; among other things.
In addition to this issue, the report also reiterates the regulators’ concern about fund managers defaulting to paying distributions in fund units, rather than cash. If a fund offers a choice to receive distributions in cash or units, the investor should have that choice, rather than relying on a default option, it says.
“We are concerned that these default options could interfere with the client/advisor relationship since they permit transactions to proceed whether or not a securityholder discusses and understands their options with their advisor,” it says; adding that the OSC will continue to review funds’ distribution policies, and the use of default options.
The report also sets out staff’s views on fund managers using proxies to demonstrate mutual fund performance in Fund Facts disclosure for instances where a certain share class has no units outstanding. “In the course of our prospectus reviews, we have noticed that there are certain scenarios that are not contemplated by the form requirements, which could lead to inconsistent or unclear disclosure,” it says.
For instance, in situations where there are gaps in the performance records of certain share classes, “it may not be possible to show performance for a complete calendar year, or to calculate an average annual return”, it notes. In these cases, regulators say they are asking fund managers to use alternative ways of disclosing past performance, such as determining a “proxy” for the missing performance information.
“In selecting the proxy class or series, the fund manager should ensure that the fees are not lower than those of the class or series with the asset gap,” it says. “In addition, the proxy class or series should not have any special features that would cause a material difference in performance.” Additionally, the disclosure in Fund Facts should include a notation indicating that the performance of a proxy is being used, it says.
The report also spells out its approach to various other issues, including: the use of dual class structures in flow-through limited partnerships; prospectus disclosure of the offering expenses of split share companies; exchange-traded fund (ETF) redemptions; and, certain disclosure issues in connection with closed-end funds.