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Update

Tuesday, October 13, 2020

Introduction

On September 18, 2020, the Canadian Securities Administrators (the “CSA”) issued CSA Staff Notice 81-333 – Guidance on Effective Liquidity Risk Management for Investments Funds (the “Staff Notice”) to provide investment fund managers (“IFMs”) with practical guidance on developing and maintaining an effective liquidity risk management (“LRM”) framework for the asset pools they administer.

In the Staff Notice, the CSA define liquidity risk as a liquidity/redemptions mismatch resulting in a fund being unable to satisfy the redemption requests of its investors without materially impacting the remaining securityholders of the fund.

The Staff Notice is timely as both the international Financial Stability Board and the Bank of Canada have previously referenced the potential systemic risk and structural concerns that could be triggered via liquidity risk due to a significant increase in certain asset management activities. In particular, it is the upward trend of open-ended fixed-income mutual funds offering daily redemptions with large holdings of corporate bonds that may be difficult to sell on short notice. It is this trend that prompted the International Organization of Securities Commissions to issue a report in 2018 recommending that IFMs should focus their efforts in preventing liquidity/redemption mismatches from arising, rather than seeking to mitigate their impacts due to the adverse effect a decline in liquidity could have on the financial system.

The CSA noted that Canada has a robust asset management regulatory framework which includes a general statutory duty of good faith and duty of care of IFMs (the “IFM Statutory Conduct Standard”), and that both National Instrument 81-102 Investment Funds (“NI 81-102”) and National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31-103”), contain provisions aimed at the responsibilities of IFMs in managing liquidity risk.

The Elements of an Effective LRM Framework

The CSA acknowledge that the management of potential liquidity/redemption mismatches are a key focus for regulators globally, and that this guidance on effective LRM practices, while not meant to suggest a “one-size fits all approach”, is intended to support the existing regulatory framework and to generally promote the interests of investors, the investment funds though which they hold their investment, as well as the broader financial system.

The Staff Notice contains certain guidance for establishing and maintaining a robust and effective LRM framework, including the following five key elements:

1. Strong and Effective Governance

In practice, IFMs have discretion to determine effective LRM governance procedures since securities legislation does not prescribe detailed requirements regarding every aspect of the management of a fund. The CSA view governance as an essential element for an effective LRM process and suggest charging an existing group or forming a specific governance committee with specific risk oversight that primarily focuses on material LRM matters. Functions of the committee may include establishing reporting and escalation procedures for material liquidity events, ongoing review of LRM policies and procedures and identifying portfolio valuation issues and internal control deficiencies.

2. Creation and Ongoing Maintenance

The CSA expect IFMs to have LRM processes that are consistent with the IFM Statutory Conduct Standard, in addition to their obligations under NI 81-103 and NI 31-103. Recognizing that a fund’s liquidity risk profile may change over the lifecycle of the fund and in varied market conditions, the Staff Notice identifies six principles that support creating and maintaining an effective LRM framework to address this issue. These include: (i) timely reporting of material liquidity events, (ii) setting internal liquidity thresholds, (iii) perform active, ongoing portfolio monitoring, (iv) adopting policies and procedures that integrate LRM, (v) aligning policies and objectives with the fund’s liquidity profile of assets and redemption demands, and (vi) proactively identifying potential liquidity events.

3. Stress Testing

While not required under securities legislation, stress tests can be an effective LRM tool which can better prepare a fund to respond to liquidity risks in an appropriate and timely manner. The Staff Notice outlines the stress testing process as follows: (i) Identification of risks, including, but not limited to, market and redemption risk, (ii) fund-proportionate stress test thresholds, (iii) historical or hypothetical scenario analysis, (iv) fund-specific frequency of stress testing, and (v) results analysis to illustrate and quantify a fund’s vulnerabilities.

4. Prospectus, Annual Information Form and Continuous Disclosure of Liquidity Risks

The CSA are of the view that material liquidity risks are material risks for the purposes of satisfying full, true and plain disclosure in a fund offering document such as a prospectus. Additionally, policies and procedures relating to LRM, as well as information regarding the group responsible for its oversight should also be disclosed to investors in a fund’s annual information form. The CSA also suggest that funds provide investors with a narrative discussion of any significant liquidity challenges or events it has faced and how they were addressed as part of the fund’s continuous disclosure obligations.

5. LRM Tools to Manage Potential and Actual Issues

The Staff Notice acknowledges that certain circumstances call for the use of LRM tools to address ongoing liquidity management issues outside those specifically provided for under securities legislation (e.g. suspension of redemptions under NI 81-102). CSA staff will consider exemptive relief from NI 81-102 to permit the use of such liquidity tools on a case-by-case basis, subject to two overarching principles: (i) there are exceptional circumstances and the tool is used sparingly and temporarily, and (ii) where it can be demonstrated to be in the best interest of a fund’s investors as a whole.

Conclusion

The Staff Notice highlights the concern surrounding the risk of liquidity/redemption mismatches in the asset management sector, given its potential as a source of systemic risk. Since material liquidity problems are more challenging to resolve after they occur, a proactive and preventative approach to LRM is critical for funds and its investors. The CSA encourage IFMs to incorporate the five key elements for creating and maintaining an effective LMR framework as part of a broader total risk management process that is consistent with, and builds on, the IFM Statutory Conduct Standard and current regulatory framework.

If you have any questions with respect to the matters discussed above, please contact Geoffrey Cher by email at gcher@wildlaw.ca or any other member of our Asset Management & Investment Funds practice group.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.