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Document MF #144
March, 2005
Exemption Order Relief-good or bad for investors?
Exemption order- what is it?
A Oct. 1997 discussion document by Benham, Campbell, Gagliardi & Soden at
http://www.osc.gov.on.ca/About/Speeches ... liance.jsp articulates
the underlying rationale for regulatory exemptions ―.. Since the early 1990's, securities
markets have undergone rapid and substantial changes including the extended "bull
markets", technological advances, increasing globalization, a rapidly growing securities
industry (particularly, an increasing number of registrants) and a greater number of novel
and complex financial instruments. All of these factors cause market participants to
impose increasing demands on securities regulators, including, most significantly, faster
response times. Securities regulators recognize that they must become more efficient to
meet the demands of industry participants‖ We stress the words ― industry participants ”
There is no comparable provision for a fast track mechanism for investors to correct
deficiencies subsequently discovered in rules and regulations. Investors have waited for
over a decade and still no fund governance requirements are in place.
An exemption order is basically a decision of a provincial securities Regulatory
Commission that says that a specific part of the Securities Act, regulations or rules
relating to the trading of securities in that province does not apply under certain
conditions. (or that the part can be amended under specified conditions). Investors can
spend many man-years striving for the adoption of new investor protection laws, while
the OSC Staff, with the signature of two Commissioners, can grant exemptive relief
from any of these laws. Investors may not intervene before or after the exemptive relief
decisions. Commissioners say they do not have any authority to give notice of these
exemptive relief applications or to hold public hearings before such decisions are
made. Investors may not communicate with the Commissioners making these exemptive
relief decisions to determine the reasons for these decisions. The Commissioners are not
obliged to publish any reasons except to the applicants, usually the mutual fund
companies. The final decision is posted on the regulators website but not communicated
to the public at large.
Often this relief allows a mutual fund company to avoid compliance with some sections
of the official requirements or to modify the original requirements with the blessing of
the applicable provincial securities regulator(s). For mutual fund investors the main
documents of interest are NI81-101 Mutual fund prospectus requirements, NI81-102
Mutual funds and NI81-105 Mutual Fund sales practices. It’s up to the securities
commissioners hearing the relief application to consider the possible ―public interest‖
implications of a proposed exemption, and to apply this test on a case-by-case basis.
Although mentioned frequently, the concept of the ―public interest‖ isn’t well defined in
the legislation; it is typically interpreted as a regulatory commission’s general obligation
to balance investor protection with fair and efficient capital markets.
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In this document we examine whether the relief offered by regulatory exemptions is in
fact balanced and in the best interests of mutual fund investors. Or is it slanted towards
industry participants managing $0.5 trillion in assets?
A little background
Before a National Instrument becomes part of securities regulation it goes through a long
complex process of public commentary. Typically, the overwhelming majority of the
commentary comes from industry participants, law firms and industry lobby groups. .
The comments from the industry typically attempt to clarify, narrow, water down,
eliminate or delay implementation if they perceive the new regs are not in their best
interests. If they perceive a change is positive for the industry they will naturally try to
pre-emptively embed it into regulatory thinking. Lobbyist organizations like IFIC
naturally propose what they believe is in the best long term interests of the fund industry.
Despite this, some investor protection aspects survive the onslaught. After a series of
compromises, tradeoffs, deliberations and delays, the Regulation or National Instrument
is eventually issued. That’s when the real fun begins.
Exemptions may be appropriate to address new products, to clarify points (If what an
applicant proposes to do does not EXACTLY conform to the letter of the law -not the
intent, the letter- an applicant is often better off applying for exemptive relief) or other
aspects not anticipated or present when the regulation was drafted. Some exemptions are
private matters but many open the door to exemption requests from all competitors of the
fund company given the original relief. After a period of time the accumulated
exemptions can be used in an update of the regulation. Exenption decisions are posted on
regulatory web sites.
It costs about $1500 to file an exemption request with the OSC plus legal expenses to
craft the document .Any of Canada’s 13 regulators can grant an exemption and in most
cases under the Mutual Reliance Relief System (MRRS) the other provincial regulators
will recognize it [NP12-201 Mutual Reliance Review System for Exemptive Relief
Applications]. We don’t have stats to show what percent of requests are turned down, if
any, but we’re sure clear about is what those exemptions approved did to the original
intent of the Reg. Exemptions can be filed by an individual firm or a group of firms. In
any event, once granted to any firm, other firms can request similar treatment which is
exactly what happened with the non-delivery of mutual fund Annual reports. Basically,
the exemption became an industry-wide practice. Securities commission normally apply
terms and conditions to its exemption decisions, including sunset clauses that grant relief
for a specified time so firms can rely on the relief only until a rule is in place. Practically
speaking, some relief decisions would be difficult and very costly to unwind.
Relief -The easing of a burden; protection given by law; release from
obligation or duty; lightening of something distressing
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Why are these exemptions important to investors?
From an investor point of view, exemption orders raise the following issues:
they are not exposed to public critique as are new regulations. In fact, they are
part of a system that generally, but not always, erodes the original regulatory
intent in an non-transparent manner
relative to requests for new investor protection measures exemptions are
expeditiously approved
it is difficult for even informed investors to be aware of the exemption. The
regulatory document configuration management system makes it difficult to
readily identify all the amendments and exemptions to regulations
time and energy must be expended to discover the exemptions, a task not made
easy by hard to navigate regulatory websites.
the relief is only available to market participants; individual investors and
consumer protection associations must wait patiently for regulations to change
they sometimes allow a cutback on unitholder services without a corresponding
definitive reduction in fees.
The cost of the additional monitoring, staff, systems and reporting is directly or
indirectly ultimately borne by fund investors as are the applicable legal expenses
for exemption applications
unless mutual fund investors continuously monitor the OSC/SEDAR web sites or
subscribe to Carswell, investors are left with the mistaken impression that
regulations are in place to protect them from conflicts of interest. Should some
Canadian banks merge, the conflicts will be larger and more frequent unless
accompanied by a requirement for the banks to divest themselves of either their
brokerage arms or mutual fund businesses.
If it is discovered that the exemption terms were breached, it is not clear what
penalties would be imposed or how investors would be made whole in the event
of a loss
Exemptions increase both compliance and enforcement costs and ultimately the
cost to investors
Investor advocates argue that permitting regulatory exemptions ahead of final rule
approval makes a mockery of the whole public comment process.
Some examples
The good old days of hidden commissions and flying to Hawaii for a ―seminar‖ at a fund
company’s (i.e.. unitholders) expense created a horrible image problem in the nineties. The media,
investor advocates, and regulators just got so sick of the horror stories that the fund industry
responded by introducing a Sales Code (now a regulation NI81-105 Mutual Fund Sales Practices),
designed to ban the worst of the excesses. Yet, during the spring of 1999 the CSA/OSC allowed
Assante Canada, contrary to NI81-105, to rebate client early redemption penalties if they switched
to a proprietary Assante fund. Many observers regarded this redemption and conversion [from third
party mutual funds] of their clients’ portfolios as self-serving and not in the best interests of
investors. What the exemption did do is simplify and legitimize fund churning and enhance the
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management fees that Assante would collect .Yes, there were some constraints attached but the
exemptive relief was regarded as an unprecedented victory for the industry. Today, Assante is being
investigated by the OSC for its sales practices in the nineties.
In May 2001 mutual fund firms, after intense industry lobbying, were exempted from the restriction
regarding the lending of fund portfolio securities. Securities lending is a temporary loan of
securities to a borrower, against collateral, for a negotiated fee. This fee, net of expenses, could in
principle boost fund returns. Borrowers must meet stringent credit criteria as defined in the
prospectus, and typically include large investment dealers and the securities trading arms of
established international banks. Mutual funds generally participate in securities lending through
their custodians, (in the case of bank-owned funds a related- party) who act as agents or principals.
The custodian negotiates and executes loan terms, collects securities lending revenue, develops
strategies, monitors collateral value and performs appropriate administrative chores. The lending
fee is usually split between the fund company and the custodian. The main risks in securities
lending are (1) the borrower will default,(2) the collateral will drop in value or (3) there are
regulatory, political or economic problems in a given country. Another potential problem involves
operational risk, the effectiveness of the tracking systems of a lending agent that monitors the deal.
Investor advocates continue to question if the small added income for retail fund investors is worth
the risk and caution of potential conflicts-of interest. In practice, the industry had made limited use
of the exemption.
James Langton reports in the Mid- February 2003 Investment Executive -
―..Recall a couple of years ago, when Nortel Networks Corp. was overpowering the
indices, and fund firms clamoured for, and received, exemptions allowing them to go
beyond the concentration restrictions funds usually face. At the time, it seemed
reasonable to allow funds to breach concentration restrictions. But, in retrospect, those
long-held restrictions served a good purpose for investors...‖ Source; J. Langton, ―
Disclosure exemptions create uneven playing field: Some fund firms have received
exemptions from current disclosure rules, but is this fair to the others? ‖
Another important exemption order issued in July 2002 relaxed the terms under which
funds can participate in related party IPOs of debt securities. You don’t need to be a
genius to figure out the possible angles here. Let's take a look at an example. Say CIBC
World Markets is floating a new issue of a bond or preferred share. Under NI 81- 102
section 4.1 (I) CIBC mutual funds would have to wait 60 days before being able to
invest; with the waiver in place investors might be hurt in several ways:
the availability of a ready market for an IPO may cause a decision to price the
IPO higher than would otherwise the case or to fill a demand gap in an under-
subscribed IPO
it encourages further erosion of the mythical ―ethical walls‖ between mutual
funds and their brokerage affiliates; these are the same walls that supposedly
existed between analysts and investment bankers
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Mutual funds may end up buying unsuitable or non-optimum investments merely
to placate superiors and/or receive rewards for such actions
The mutual funds can be used to artificially prop up a weak IPO to prevent it from
tanking too shortly after distribution
The effectiveness of independent ― monitors‖ is a real question mark. It’s hard to
see how in practice a monitor would be able to effectively question or ban a
portfolio managers’ potentially conflicted purchase decision
Sometimes waiting 60 days allows the market to establish a more rational price of
the security; buying early may prove to be expensive
―Hot‖ IPOs can be used to turbo- boost short-term fund returns to increase fund
sales; retail investors traditionally chase well-publicized returns.
if it turns out the IPO was based on material misrepresentations it's highly
unlikely the affiliated fund would participate in litigation or class actions to
recover losses from the related dealer on behalf of unitholders
―…In the 1920s, Goldman Sachs, Lehman Brother sand other investment banks
organized mutual funds [in the U.S.] to provide a market for stocks the bankers brought
to market. The abuses that arose from this practice were the subject of years of
investigations in the 1930s. In the course of the investigations, a senior Goldman Sachs
partner testified before the then-fledgling SEC, "I don't think there is any doubt about it,
when you form an investment company and sponsor it, you get income from stock
exchange business and income from relationships created." Some things never
change….‖
-Source: Mercer Bullard, ― Another Chink in the Wall: SEC Grants Self-Dealing
Exemption to Goldman Funds‖, 3/1/2001 [the story deals with the case permitting GS
funds an exemption from self-dealing prohibitions so that it could trade securities with
the funds it advises.
http://www.thestreet.com/funds/mercerbu ... 25120.html An Exemption granted in Dec. 2002, just before Christmas, now permits fund companies
to only send you Annual reports if you expressly request them. This is regarded as anti –
investor as it permits a fund Company not to mandatorily mail you a copy of the most
fundamental of disclosure documents. There may or may not be a reduced MER, but if
10-year trends are an indication, most cost savings, one of the cited reasons for the
request, will accrue to the fund Company. According to former OSC Commissioner
Glorianne Stromberg financial statement disclosure is an integral part of the material
information relating to a mutual fund. Measures that decrease the likelihood of timely
delivery of such information to unitholders undermine the core regulatory strategy of
requiring mutual funds to make mandatory and timely disclosure of material information
on a continuing basis so that investors are kept fully informed at all times. For disclosure
to be effective, it is not enough just to prepare the information. It has to be
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comprehensible ( in plain language) , relevant and to be actually delivered to fund
investors in a form they can use before it can be considered to be disclosed to them.
Investor advocates howled upon belatedly hearing of the exemption but to no avail.
RBC Mutual Funds was able to bypass a unitholder vote regarding a change of auditor.
The change was made without the knowledge or concurrence of investors via a March
25,2004 OSC Exemption to established regulations. An undated letter distributed April
22 from Brenda Vince, President, RBC Asset Management was the first indication
investors had that a change had occurred. The 2003 financial statements of the fund are
signed by PwC LLP. There is no credible rationale provided as to why investors were
shut out .In fact, Deloitte&Touche is the sole auditor of the bank and the mutual funds
complex, an unhealthy situation. The bank claims that significant costs were saved by
requesting an exemption rather than mailing out a voting circular to all unitholders.
Apparently no request for bids were sent out to other possible auditor contenders which
might have lowered costs for the fund. The status quo with a separate fund auditor would
actually have been preferable and cheaper for unitholders. It seems that regulators, banks
and fund factories need to be reminded as to exactly whose money it is.
Yet another exemption in March, 2004 allowed conventional mutual funds to sell
securities short, a practice banned since the 1929 market crash. Despite critical
commentary from investor advocates, SIPA and others, the CSA/OSC now permit the use
of shorting by mutual funds. This Regulatory Exemption order is the culprit in bringing
the once relatively stable mutual fund into hedge fund territory. So much for investor
protection. Regulators have required funds that short-sell stocks to adopt certain
protective measures, including a 10-per-cent asset hedging limit, a cash cover equal to
150 per cent of the value of the security sold short and a requirement to purchase the
shorted security if it exceeds 108 per cent of the short price.
However, in a well-reasoned piece that appeared in the August, 2004 THE
FUNDLETTER Selling mutual fund investors short, author David West, a CFA, argues
convincingly against the practice. He argues that the 150% figure basically introduces
leveraging into a fund. Shorting, he warns can sometimes result in losses far greater than
8% due to short –squeezing, a takeover bid or the winning of a major contract. West
argues that shorting is fundamentally at cross-purposes with the traditional use of mutual
funds to provide a diversified portfolio of quality companies to reduce issuer-specific
risk. He thus feels that risk is being increased and small retail mutual fund investors may
not comprehend the risk implications. West reminds us that short sellers must make up
any dividends paid by shorted stocks and that the lender may recall the stock at a time
inconvenient to the fund. However, one thing the new approach does is give Dynamic,
National Bank and CI Funds a marketing tool to combat hedge funds who are attracting
assets. AIM Funds Management Inc. appears to be the most outspoken short-selling critic
- VP Dwayne Dreger notes that the firm's value-driven investment style "is all about
buying good businesses and not about shorting bad ones".
We won’t even talk about regulatory oversight and fund governance to track and monitor
all this. We also ignore the fact that mutual funds can’t distribute losses, they can only
carry them forward to offset against potential future gains. Additionally, some hedge fund
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market analysts think this idea may generally lead to conflicts- of -interest when the same
manager manages a hedge fund and a mutual fund.
Still another exemption allows mutual funds to purchase shares in their parent company
(or hold debt of affiliates) leading to potential conflicts- of- interest considering the
generally ineffective track record of monitors. [The precedent was established in July,
2002, when Mackenzie Financial was allowed to acquire shares in Power Corp., Power
Financial and Great-West Life.] For instance a bank- owned fund would not have been
allowed to buy shares in its parent thus supposedly putting the fund at a competitive
disadvantage with independent fund companies who do not have this conflict-of interest
.In Canada’s small market where nearly half of the TSX market cap is attributed to its 60-
stocklarge cap universe but only 3% of listed securities the argument may have some
validity. This related- party prohibition was originally deemed necessary for investor
protection but, with the passage of time, mutual fund growth and industry consolidation,
has been watered down. A January 2004 OSC exemptive relief decision for example lets
Winnipeg-based Investors Group invest [and vote the proxy shares] client mutual fund
assets in the stocks and debt instruments of Great-West Life Assurance Co., Power
Financial Corp., Power Corp. of Canada, Canada Life Financial Corp., Canada Life
Assurance Co. and Canada Life Capital Trust subject to the establishment of a unelected
Investment Review Committee. Truly a family affair. The consequences? Added costs for
unitholders, questionable oversight, potential conflicted voting of fund shares and
constraints on timely disposition because of the ―special relationship‖ with related
parties.
It’s true that most exemption decisions have constraints imposed but investor advocates
and investors view them with cynicism .To start with , there is little regulatory
meaningful follow-up to check that the limitations imposed are actually complied with.
To critics, words like ―best efforts ‖ are not measurable or enforceable. Informed
investors have come to cynically consider the limitations as just good optics to give the
illusion of strong regulation. For instance, the exemption regarding related- party debt
securities IPO’s requires written policies, detailed records to be maintained and a host of
other costly administrative chores ultimately paid for by investors in one form or another,
but in the end the judgment of the fund manager is the sole basis for the suitability of the
investment. When Scotia Mutual Funds was granted the right to cease mandatory
mailings of Annual financial statements the provisos required that the Manager shall file
on Sedar, under the annual financial statements category, information regarding the
number and percentage of requests for annual financial statements made by the return of
the request forms and to record the number and a summary of complaints received from
Direct Securityholders about not receiving the annual financial statements and shall file
on Sedar .So what ? argue advocates –the results are predictable- unsophisticated retail
fund investors put on a negative option basis will not request the financial statements or
their advisers will suggest they do not need them. That’s exactly what happened. So
instead of working to make Annual reports more readable and useful, the exemption
minimized their distribution since ― they don’t get read anyway‖.
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The related -party exemption also attracted significant investor advocate attention. As an
example of how this one works, an Independent Review Committee (IRC) at market
timer CI Funds, which received permission to invest in securities of Sun Life Financial
(SLF) in 2003, reviews at least every three months the decisions made on behalf of each
fund to purchase, sell or continue to hold securities of Sun Life. SLF owns 34 % of CI. It
also determines whether such decisions were, and continue to be, in the best interests of
the fund. This decision also has a significant impact on capital markets in general. The
IRC is to advise regulators if it decides any investment does not meet its criteria. SIPA
and others have forcefully argued that the criteria to determine the best interests of the
fund are virtually impossible to deal with since in the end it pits the IRC against the
judgment call of a professional fund manager. In any event, advocates claim that the
toothless IRC is merely a figurehead mirage to provide at least some legitimacy to the
investor abusing decision. To date not a single case of a conflict-of interest has been
reported by any fund company IRC-investor advocates view this statistic as evidence that
the process is useless but allows regulators to feel good that they imposed the necessary
control tools. [In Oct. 2004, controversial fundco Assante also received regulatory
approval to own, trade and vote shares of SLF, as Assante is now part of the CI
organization.]
Do conflicts-of interest really materialize among Canada’s elite financial institutions? In
September 1999 Royal Bank of Canada came under criticism for the active role two of its
mutual funds played in Onex Corp.'s hostile takeover bid for Air Canada, which Onex
wanted to merge with Canadian Airlines International Ltd. It emerged in court documents
filed that Royal Bank's trust division, acting on behalf of the two mutual funds, joined
Onex in filing an application under the Canada Business Corporations Act requesting that
Air Canada advance a shareholder vote on Onex's hostile bid to Nov. 8 from the Jan. 7
date the airline had set. Royal Bank has long been a major lender to financially troubled
Canadian, while two of its mutual funds together own about 2.5 million shares of Air
Canada -- about 2 per cent of the outstanding -- which fought the Onex bid. The
perception this raised in some quarters is that the interests of unitholders in the bank's
Royal Balanced Fund and Royal Canadian Equity Fund were playing second fiddle to
those the parent bank had as a major creditor of Canadian.
The bottom line
Mutual funds are a wonderful and convenient vehicle for small retail investors to invest
for their retirement or other goals. BUT, they need to be managed at all times in the best
interests of unitholders and without undue risk .
The practical effect of exemption relief decisions is to allow some industry participants,
to operate as if new rules were in place, despite the fact that they may still be out for
comment, or, in the case of fund governance, still at the conceptual stage. Risks due to
exemptive relief have definitely increased for investors without the benefit of a protective
fund governance framework or investor input.
Exemption decisions are yet another example of how securities regulation is tilted in
favour of what the financial services industry, especially the big banks and insurers,
wants, or is prepared, to accept. Seemingly little regard is given to the needs of investors,
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fairness or transparency — despite the fact that everything is claimed to be done ―in the
public interest.‖ All of this against a backdrop of a weak mutual fund governance
processes, loose regulatory enforcement , U.S. and Canadian fund scandals, prospectuses
that obscure rather than illuminate and wishy-washy annual reports/financial statements
that don’t really discuss the operations of the fund, break out important costs or articulate
how it made (or lost) money during the reporting period.
The biggest fear now for those interested in investor protection is that the latest
CSA/OSC missive, NI 81-107 Mutual Fund Governance, will officially eliminate all the
historical protective prohibitions, and replace them with a powerless IRC. This
premeditated attack on investors was so egregious that for the first time individual
investors, investor advocates, academics, consumer groups, CARP, the media, fund
analysts and even a few industry participants combined forces to counterbalance the
awesome half trillion dollar fund industry lobbying machine. Ironically, if passed in its
existing form, there will be a lot fewer exemption requests since virtually nothing will be
prohibited and nearly everything will be handled by the so-called powerless IRC’s.
Worse still, one contributor to this piece, who wishes to remain anonymous, observed ―
There are so many clandestinely obtained exemptions out there that NI81-107 is already
the de facto law. An investor relying on regulations for protection is like standing on Jell-
O upon a foundation of quicksand ‖ Another cynic pointed out that none of this matters.
She said ―Who cares about exemptions when there is lax enforcement of any rule and
investor restitution is almost impossible to obtain. Read John Reynolds the Naked
Investor for the bitter truth about investor protection in Canada‖
If the mutual fund market timing scandals taught us one lesson it’s that enhanced, not
reduced, fund governance is mandatory. In that case ,effective fund governance would
have (a) reacted to the defective valuation process for international funds (b) imposed a
early redemption penalty and (c) told the frequent traders to go elsewhere. Fund
governance is a cost-effective measure that will reduce ( but not guarantee) the chances
of inappropriate behaviour and practices. We await the next move from politicians and
regulators but here’s some ideas. Because individual investors ultimately pay for the
consequences of these sorts of decisions, the regulators should be funding a Financial
Consumer Advisory Panel to represent investors’ interests in proposed new rules and
exemptions to those rules. Another idea, establish a true fund governance regime and toss
the IRC concept out the window.
Ken Kivenko P. Eng.
Investor Advocate
kenkiv@sympatico.ca DISCLAIMER
Information contained herein is obtained from sources believed to be reliable, but
the accuracy is not guaranteed. The material does not constitute a recommendation
to buy, hold or sell. The purpose of this Document and others in the series is to
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educate investors by bringing together personal finance information from a variety
of sources. It is not intended to provide legal, investment, accounting or tax advice
and should not be relied upon in that regard. If legal or investment advice or other
professional assistance is needed, the services of a competent professional should be
obtained.
