Capital markets and structured investments

The establishment and operation of a fund and the offering of fund securities is subject to regulation under the securities legislation and the oversight of the securities commission of each province. Private equity funds and hedge funds are only indirectly regulated unless they file a prospectus; however, such funds may only sell their securities in compliance with available prospectus exemptions, and must comply with applicable dealer registration requirements.

Each of Canada’s ten provinces and three territories has its own securities laws, administered by a local securities regulatory authority. However, in a growing number of areas, including investment fund regulation, the rules have been largely harmonised across the 13 jurisdictions.

The key regulatory instruments that apply to offering fund securities and operating a fund, among other things are:

• National Instrument 81-101 – Mutual Funds Prospectus Disclosure (NI 81-101) that regulates projects disclosure requirements for mutual funds;
• National Instrument 81-102 – Investment Funds (NI 81-102) that sets out core investment restrictions and fundamental operational requirements;
• National Instrument 81-105 – Mutual Funds Sales Practices (NI 81-105) that regulates the sale of mutual funds;
• National Instrument 81-106 – Investment Fund Continuous Disclosure (NI 81-106) that sets out continuous disclosure requirements for investment funds; and
• National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) that regulates registration requirements and the activities of registrants.

Common forms of funds include:

• Open-ended retail funds – are also referred to as mutual funds and are pooled funds that generally issue securities or units continuously.
• Closed-ended retail funds – are also referred to as non-redeemable investment funds. These typically raise a fixed amount of capital through a public offering and many are listed on capital markets.

Retail funds

Both closed-ended and open-ended funds that wish to sell securities to the public must file a prospectus and comply with continuous disclosure and other applicable regulatory requirements, as well as exchange rules and policies where the securities of the fund are publicly listed. The funds must also comply with applicable registration requirements under NI 31-103.

Foreign funds in many cases will be able to sell its foreign securities to Canadian investors without being registered in Canada, provided the fund:

• sells only to ‘permitted clients’;
• meets all requisite conditions; and
• complies with certain filing requirements (as set out under NI 31-103).

Institutional/professional funds

Institutional or professional funds are not recognized as a separate category and the offering of securities by an institutional fund would depend entirely on the form of the fund. Where the fund is marketing to the public, it must file a prospectus and comply with continuous disclosure and other applicable regulatory requirements, as well as exchange rules and policies where the securities of the fund are publicly listed. Alternately, as is more often the case, funds targeted at institutional investors do not offer securities to the public and generally offer securities by way of a private placement under a prospectus-filing exemption.

Establishing funds

Managing investments is a regulated activity in Canada, and dealers and financial advisors must be registered with the applicable securities commission. Similarly, individuals acting on behalf of registered firms must also be registered under the applicable category.

Investing in funds

Investment in funds is subject to generally the same risks as investment in any other security.

Retail funds can be marketed by registered dealers. Mutual funds are typically distributed to retail investors by either:

• investment dealers; or
• mutual fund dealers.

Exempt market dealers can also market prospectus qualified, open-ended funds to eligible investors under a prospectus exemption. The most common prospectus exemption is the accredited investor exemption. Under this prospectus exemption, securities can be distributed to a purchaser that qualifies as an accredited investor, including:

• an individual who alone or with a spouse has either CA$1 million in financial assets or CA$5 million in net assets;
• an individual who had net income before taxes exceeding CA$200,000 in each of the two most recent calendar years (or CA$300,000 when combined with income of a spouse);
• a Canadian financial institution or Schedule III bank;
• an advisor or dealer;
• the Government of Canada or a jurisdiction of Canada (including crown corporations and agencies);
• a municipality, public board or commission in Canada;
• certain pension funds; and
• certain investment funds.

Institutional investors that are ‘permitted clients’ may be less relevant for retail funds but are the focus of hedge and non-resident funds.

A firm registered as an investment dealer or mutual fund dealer must generally be a member of a self-regulatory organization. Investment dealers must generally become members of the Investment Industry Regulatory Organization of Canada (IIROC). Mutual fund dealers must generally become members of the Mutual Fund Dealers Association of Canada (MFDA).

Registered dealers, including mutual fund dealers, are subject to ‘know your client’ (KYC), ‘know your product’ (KYP) and suitability requirements that are collectively intended to ensure that purchases of securities are not incompatible with the client's circumstances, risk tolerance and investment goals.

Under KYC requirements, dealers must take reasonable steps to establish the identity of a client and to ensure that they have sufficient information to meet their suitability obligation. Under suitability requirements, a dealer must obtain, understand and is expected to explain how a proposed investment is suitable for the client in light of the client's investment needs and objectives, including the client's:

• time horizon for its investments;
• financial circumstances (including net worth, income, current investment holdings and employment status); and
• risk tolerance for various types of securities and investment portfolios, taking into account the client's investment knowledge.

Registrants must conduct their own product due diligence and be able to explain to clients the security's:

• risks;
• key features; and
• initial and ongoing costs and fee.

NI 31-103 provides for the registration of persons in connection with trading or advising in securities, investment fund management and other related matters.

The key requirement is registration as an investment fund manager (IFM), which is defined as a person or company that directs the business, operations or affairs of an investment fund. IFMs are subject to a statutory duty to act in the best interests of an investment fund. The regulators considered extending ‎this duty of care to other categories of registrants, however, subsequent to an extensive consultation period, the regulators ‎published a set of proposed amendments which impose new requirements, codify best practices in existing guidance, and ‎clarify the client-registrant relationship. These amendments are expected to come into force on December 31, 2019, subject to receiving required provincial approvals, with industry participants being required to comply over a two-year phased transition period.

An IFM that acts as a portfolio advisor or that distributes securities of its own funds must also register as a portfolio manager (PM) or as an exempt market dealer (EMD), respectively. All registrants, including EMDs, must:

• meet minimum capital and insurance requirements;
• adopt written compliance policies and procedures;
• file periodic reports with the principal securities regulator and maintain certain records; and
• identify, disclose and manage conflicts of interests.

Fund managers must disclose, on a quarterly basis, net asset value (NAV) adjustments. In addition, all registrants must file audited financial statements with the regulators. IFMs of funds that are reporting issuers must comply with the requirements of National Instrument 81-102 (NI 81-102), NI 81-106 and NI 81-107.

Dealers and advisors are subject to best execution requirements under NI 23-101 (Trading Rules) and rules regarding soft dollar arrangements under NI 23-102 (Use of Client Brokerage Commissions).

The regulation of derivatives in Canada, like securities, is governed by individual provincial regulators. However, provincial regulators have generally enacted uniform regulations in respect of derivatives, which are substantially similar to those in the US and in the EU, all as part of its G20 commitments following the global financial crisis in 2008.

Dealer registration requirements exist to the extent a party is engaged in the ‘business of trading derivatives’. There are a number of indicia to indicate if and when a party is considered a dealer and whether or not they are subject to registration requirements.

Over-the-counter derivatives transactions in some jurisdictions in Canada are treated as trading in securities and are thus subject to securities laws. To be exempt therefrom (pursuant to blanket orders in individual jurisdictions), parties to over-the-counter derivatives transactions must represent that they are of a type of sophisticated counterparty that ensures they are aware of and have adequately assessed the risks associated with these types of transactions. There are a number of criteria included in such blanket orders for purposes of determining a party’s ability to trade derivatives relating to the type of entity and net worth of any such individual or entity.

Derivative contracts are entered into in Canada for a range of reasons including foreign exchange, currency, commodity, hedging and speculation.

Derivatives may be traded over-the-counter or on an organized exchange.

All of the main types of derivative contracts are widely used in Canada:

• forwards;
• futures;
• swaps (such as interest rate or currency swaps); and
• options (call options and put options).

The value of the derivative contract is based on the value of the underlying assets. The main classes of underlying assets seen in Canada are:

• equity;
• interest rates;
• commodities;
• foreign currency; and
• credit events.

Certain types of standardized over-the-counter derivatives, including interest rate swaps and foreign rate agreements, are also subject to mandatory clearing.

Since the global financial crisis in 2007-to-2008, derivatives and particularly over-the-counter derivatives have attracted significant regulatory attention. Canada, in line with the G20 Commitments, has sought in particular, to:

• enhance transparency by requiring the provision of comprehensive information on over-the-counter derivative positions;
• reduce counterparty risk by increasing the use of central counterparty clearing; and
• improve the management of operational risk by increasing the standardization of derivatives contracts.

As a result, the derivatives market has seen and continues to see the introduction of a significant amount of new regulation and this has led to substantial compliance costs for market participants. In particular, the new regulations are focused on trade reporting, dealer registration, mandatory clearing and margining to reduce credit and market risk.

In addition, derivatives are subject to normal market and counterparty credit risk and, as a result, are designed solely for sophisticated entities.