Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 14 - Evidence - Meeting of June 8, 2005
OTTAWA, Wednesday, June 8, 2005
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:06 p.m. to examine and report on consumer issues arising in the financial services sector.
Senator W. David Angus (Deputy Chairman) in the chair.
[English]
The Deputy Chairman: I call the meeting to order. I am Senator David Angus, Deputy Chairman of the Standing Senate Committee on Banking, Trade and Commerce. I have the privilege today of presiding over this special meeting in the absence of the Chairman, Senator Grafstein.
I extend a warm welcome to honourable senators and witnesses present and to television and Internet viewers across Canada who are watching these proceedings on CPAC and on the World Wide Web. This is the penultimate meeting with witnesses in our committee's oversight study on consumer protection issues arising in the financial services sector.
As Senator Grafstein said at the first meeting of these hearings last November 18:
Banking is more than just buying and selling money, it is about consumer confidence in the financial system... about keeping the economy strong and growing. The committee believes that parliamentary oversight is integral to the public confidence in the financial system and safeguarding the interests of all consumers.
It was in this spirit that we arranged for today's special hearing into certain aspects of the hedge fund industry in Canada before concluding our consumer study. This is a relatively unregulated area of our financial services sector, which has grown like Topsy in recent years and seems to be in a state of constant and profound change. As of 2004, an estimated $26.6 billion was invested in hedge funds in Canada, at least half of it by retail investors.
On May 18, 2005, the Investment Dealers Association of Canada (IDA) issued a report on hedge funds that highlighted the need for a review of the applicable Canadian laws and regulations, and called for the inclusion of hedge fund products within Canada's regulatory system. While this falls primarily within provincial jurisdiction, the implications are federal in scope; and this committee believed that it would be remiss if it issued its report without some educated references to current hedge fund issues and concerns.
In this spirit, we are fortunate to have with us today witnesses from the Investment Dealers Association of Canada and from the Alternative Investment Management Association Limited (AIMA) to assist us in understanding hedge funds and their relevance to Canadians, especially from a consumer, retailer or investor protection perspective. Gentlemen, please proceed.
Mr. James McGovern, Chairman, Alternative Investment Management Association Limited: I will proceed with the formal report, which should take five or 10 minutes, and then we can have questions.
I am chairman of the Canadian chapter of AIMA, and with me is Gary Ostoich, who is AIMA Canada's legal counsel. We would like to thank the Standing Senate Committee on Banking, Trade and Commerce for the opportunity to meet with you and provide information regarding the hedge fund industry in Canada.
In the time allotted to us today, we will cover six areas: (1) who AIMA Canada is; (2) the role of hedge funds in capital markets; (3) the size and constituents of the Canadian hedge fund market; (4) regulation of hedge fund products in Canada; (5) current issues relating to hedge funds; and (6) the future of the Canadian hedge fund industry.
AIMA Canada is a chapter of the Alternative Investment Management Association Limited, which was established in the U.K. in 1990 as a direct result of the growing importance of alternative investments in global investment management. AIMA is a not-for-profit educational and research body that represents practitioners and institutional investors in hedge funds, managed futures and managed currency funds, in addition to suppliers to the industry such as prime brokers, administrators, lawyers and accountants.
AIMA's global membership comprises some 700 members in over 43 countries around the world, including the United Kingdom, France, Germany, Netherlands and Switzerland. It also has chapters in Australia, Hong Kong, China, Japan, Singapore, South Africa and Canada. AIMA Canada was established in March 2003, and has grown to over 70 corporate members, including some of the largest institutional investors in Canada, as well as some of the largest Canadian-based hedge funds and funds of hedge funds.
AIMA works closely with regulators and other interested parties around the world to promote the responsible use of alternative investments. In addition to providing complementary copies of educational materials produced by or on its behalf, AIMA holds both formal and informal discussions with regulators on behalf of its members. Examples of regulatory initiatives and material published by AIMA Canada include: ``A Guide to Sound Practices for Canadian Hedge Fund Managers,'' which provides Canadian management with an overview of the many issues that should be considered by a hedge fund manager; ``AIMA Canada Hedge Fund Primer,'' which is investor-friendly background material relating to hedge funds as an asset class; and providing comments and feedback on various industry regulatory guidelines and rules, such as National Instrument 81-106. We are currently working on a paper to be released on June 14, entitled ``A Guide to Sound Practices for Disclosure and Promotion of Alternative Investments in Canada,'' which contains detailed guidelines on disclosure and promotion of hedge fund products in Canada.
In its 2004 financial review system, the Bank of Canada stated that the term ``hedge fund'' covers a very diverse field of organizations and behaviour that defy any simple definition, and we would concur with that. Generally, a hedge fund is a private investment fund limited to a small number of sophisticated clients who regularly invest relatively large sums of money. These investors rely on the expertise of portfolio managers to generate returns.
The hedge fund industry is smaller than the traditional mutual fund industry not only because of its limited capital raising opportunities, but also because it needs to remain nimble enough to make profitable trades or investments without significant market impact. Hedge funds are often described as ``absolute return investments.'' Unlike traditional mutual funds, they do not link their performance to any index or benchmark. Instead, they use the skill of their portfolio managers to implement proprietary trading strategies to generate returns independent of the movement of the broader market.
Although there are over 25 different classes of investment strategies that hedge funds may engage in, most hedge funds in Canada fall into a few categories. The most common investment strategy is equity long/short, in which a hedge fund purchases stocks it believes will rise in price and sells short those that it believes will decline in price, thus generating a profit in both rising and falling markets.
Another common strategy is a market neutral strategy, which is a variant of equity long/short in which long and short positions are matched so that the fund has limited exposure to the overall market direction. Less common investment strategies in Canada include convertible arbitrage, in which positions in convertible debt are hedged by selling short the underlying common shares, and managed futures strategies, which are based on capitalizing on trends in a variety of global markets such as currency and interest rates.
Additionally, some hedge funds use other hedge funds as their primary investments, thus creating portfolios or funds of hedge funds. Funds of hedge funds offer investors exposure to a wide variety of investment strategies selected by portfolio managers with considerable experience in the hedge fund marketplace.
Hedge funds provide significant benefits to investors, as well as the broader financial markets. Benefits to investors include portfolio diversification, because hedge funds returns traditionally have little or no correlation to the returns of more traditional stock and bond investments. Accordingly, hedge funds offer investors such as pension funds the opportunity to reduce portfolio volatility and enhance portfolio returns in economic environments in which traditional stock and bond investments offer limited opportunity. Hedge funds also provide investors with the opportunity to generate returns by investing in non-financial markets such as commodities.
They benefit financial markets by performing a number of vital roles. For example, hedge funds can act as shock absorbers in the marketplace by investing in volatile markets when others choose to remain on the sidelines. Hedge funds can also often act as whistle-blowers on companies, identifying, through shareholder activism, those companies that hedge funds believe have issues with their business or corporate governance; this can signal to corporate boards, other market participants or regulators that a problem may exist with a public company.
Hedge funds add depth and liquidity to all areas of the capital market, which contributes to efficiencies in pricing and promotes market stability. Finally, hedge funds often act as effective risk transfer conduits in the capital markets, particularly in the area of corporate and high yield credits.
The Canadian hedge fund market has continued to evolve and expand in recent years. As of June 2004, total assets in the Canadian hedge funds and hedge fund-related products totalled over $20 billion. As recently as 1999, the Canadian market was made up of less than 50 hedge funds with roughly $2.5 billion in managed assets. By June 2004, the market had grown to approximately 190 hedge funds and hedge fund-related products with $26.6 billion in assets. This should be placed in the context of the global hedge fund marketplace, which is now over U.S. $1 trillion in assets.
Approximately $14.1 billion of hedge fund investments in Canada are owned by individual investors, with approximately 50 per cent of that amount held via principal-protected notes issued by highly rated financial institutions and government entities. However, Canadian pension plan assets represent a significant amount of the funds invested in hedge funds, with over 40 per cent of hedge fund investments in Canada held by institutions.
The $14.1 billion hedge fund market in Canada consists of both single-manager hedge funds and funds of hedge funds. Of the approximately 190 hedge funds in the Canadian marketplace, about 55 per cent are single-manager funds, with an average size of $39 million. The average size of a fund of hedge funds is slightly higher at $44 million.
In addition to individual hedge fund managers, banks, mutual fund companies and insurance companies are also active in offering hedge funds and hedge fund-related products to Canadian investors. Several traditional mutual fund companies have supplemented their investment funds by establishing alternative investment funds, employing strategies such as short-selling and modest leverage, which are traditionally associated with hedge funds.
Several banks have also begun to offer hedge fund-related products, such as principal-protected deposit notes. These products offer principal protection because at maturity an investor will receive at least their principal back, together with a return linked to the performance of a hedge fund, which is typically a fund of hedge funds. These principal- protected products are primarily offered in the retail sector, and provide investors with exposure to the hedge fund sector without having to meet large minimum investment or ``accredited investor'' rules that are typically required for a direct investment in a hedge fund. In recent years, the principal-protected products have gained an increasing share of the hedge fund marketplace in Canada.
Alternative investments such as hedge funds can be structured in a variety of ways, but regardless of the legal form, the regulation applicable to the offer, promotion and sale of the hedge fund is similar. Money managers such as mutual fund managers and hedge fund managers need to be registered with provincial securities commissions in order to manage money for clients. The requirement to register with securities regulatory authorities to provide portfolio management services is an expensive and time-consuming process. It involves demonstrating significant previous experience to securities regulators as well as developing and maintaining a comprehensive compliance program for the money management firm. As a money manager registered with a provincial securities commission, a hedge fund manager is subject to a compliance audit by securities regulators.
Access to public markets in Canada is subject to numerous regulations that are intended to maintain the integrity of the Canadian financial market and protect investors. Hedge funds that offer their securities in Canada or to Canadian residents must comply with these regulations.
In Canada, hedge funds are marketed in the retail market and the exempt market. The retail market refers to distribution to the general investing public by way of prospectus offerings or other offerings that are not subject to or exempt from securities regulations, such as principal-protected banknote offerings. The most frequently relied upon exemptions used to sell hedge fund products are the ``accredited investor'' and ``pooled fund'' exemptions, as well as the principal-protected banknote offerings.
The accredited investor exemption allows institutional investors and individuals with high assets or net worth, or income above a certain threshold, to invest in non-prospectus offerings. The pooled fund exemption allows investors who invest more than a specific dollar amount in a single fund to participate in non-prospectus offerings.
It is worthwhile mentioning that, despite the growth in the high net worth segment of the exempt market, much of the investment in hedge funds tends to come from institutional investors, including pension funds, governments and Canadian and global funds of hedge funds.
Retail investors have begun to constitute a larger source of investors for Canadian hedge funds and Canadian distributors due to the advent of various structured products that are either exempted from the application of the prospectus rules or are offered by way of a prospectus. Some common products include prospectus-offered, exchange- listed, non-redeemable investment funds whose returns are linked to the performance of hedge funds, and principal- protected, hedge-fund-linked bank deposit notes.
Aside from securities regulations, Canadian hedge fund managers are also required to comply with provincial and federal privacy legislation in connection with the collection, use, disclosure and disposal of personal information about their investors. Hedge funds are also subject to certain reporting requirements under Canadian anti-money laundering and anti-terrorist financing legislation.
There are also restrictions on the advertising and promotional strategies that Canadian hedge funds can employ. For instance, securities legislation generally prohibits the promotion of privately offered investments in securities on radio or television. In certain Canadian jurisdictions, subject to strict guidelines, hedge funds are permitted to advertise an offering of securities to credit investors in newspapers and other print media.
Not unlike the bank lending market, which experiences problem loans from time to time, the hedge fund market has also had its share of problem hedge funds and distributors. In some cases, Canadian institutional investors have been caught off guard by problems that have occurred with hedge funds situated and managed outside Canada, such as the Lancer fund, whose investors included the City of Montreal, the University of Montreal, the Chagnon Foundation and Bombardier. In other cases, Canadian hedge funds have experienced losses or other problems that have resulted in the funds being closed down and liquidated.
Recently, two Canadian hedge fund-related issues have been highlighted by the press — Portus Alternative Asset Management, based in Toronto, and Norshield Financial Group, based in Montreal. Portus reportedly sold approximately $750 million in hedge fund products to 26,000 retail investors across Canada and is being investigated by various provincial securities commissions for violating securities laws. It is alleged that Portus improperly offered their products to non-accredited investors, and that neither Portus nor its distributors conducted the necessary due diligence and suitability tests with respect to recommending their products.
Norshield reportedly managed approximately $450 million in fund of funds products for mainly high net worth and institutional investors. Norshield recently announced to investors that it was preventing any further redemptions from its funds pending an orderly liquidation of its underlying investments.
Both Portus and Norsheild are still being reviewed by several securities regulators across Canada and final determinations regarding their situations have not yet been made. However, it appears that the issues surrounding these firms are very different and should not be seen as hedge fund issues per se, even though both Portus and Norshield were involved in the hedge fund business.
From our perspective, the Portus situation primarily involves compliance and due diligence issues. The compliance issue relates to sales practices and disclosure as well as to the suitability of the fund for retail investors. The due diligence concern relates to the referred selling practices involving regulated third parties who participated in the marketing and distribution of Portus products.
For Norshield, it appears there was a run on the fund by investors caused by a number of factors, including bad publicity in Quebec relating to litigation. This has caused liquidity problems in certain of Norshield's underlying funds.
One of the risks in investing with hedge funds, which is similar to other investments such as private equity, is that if too many investors want to exit a fund on a given date, the fund may not have enough liquidity to allow them to do so. Therefore, a ``gate'' will be invoked to permit an orderly liquidation of investments and exit from the fund.
AIMA Canada recognizes that as the hedge fund market continues to evolve inside and outside Canada, regulatory agencies will be reviewing existing regulation to ensure that it is broad enough to protect less sophisticated investors. We strongly support proper and adequate regulation to protect retail investors. In the United States, the Securities and Exchange Commission (SEC) recently enacted rules to require hedge fund investment managers based in the U.S., or hedge funds selling to certain U.S. investors, to be registered with the SEC, a requirement that most Canadian provinces have had in place for some time.
In summary, AIMA Canada sees strong growth in the Canadian hedge fund industry, which currently involves some of the largest and most sophisticated financial institutions in this country. The industry is strong and fundamentally sound. AIMA Canada will continue to work with industry participants and Canadian regulatory authorities to promote the responsible use of alternative investments; and to further our objective of increasing investor education and transparency and promoting due diligence and related best practices.
Senator Meighen: I have several questions regarding your outlook on the future of the hedge fund industry. First, is the popularity of hedge funds tied to the fortunes of the investment scene, that is, do low yields drive people toward hedge funds? If so, when yields increase, will the move toward hedge funds dissipate?
In the U.S., there is $1 trillion invested in hedge funds. In Canada, it is in the order of $26 billion. Do you see explosive growth in the hedge fund industry in Canada, assuming a continuing low-yield environment?
Mr. Ostoich: With regard to where we see the industry growing, many commentators think the hedge fund industry is a bit ``toppy,'' which means that there are a lot of participants in it. The hedge fund industry likely will not grow as fast as it has in the past because most hedge funds are started by entrepreneurial people, many of whom came from bank trading desks that use strategies that have existed in the capital markets for quite some time. Then they venture off and put together private pools of money to make money for their investors — and often themselves. Most hedge fund managers have a significant amount of their own capital in their fund.
They charge a lot of money for their services — typically a 2 per cent management fee, plus 20 per cent of their performance. If a hedge fund manager makes $1 million, he or she keeps keep 20 per cent of that. If a hedge fund does not perform, the money quickly leaves and the fund goes out of business.
In response to your question about where the hedge fund business is going, it is not only about the yields but about what can be extracted from the hedge funds globally in this marketplace. As we have seen in the convertible market and the merger arbitrage market, there are so many participants crowding the market, including banks and mutual funds, that the returns are not there.
Thus, large investors in hedge funds that are still globally high net worth will not tolerate low returns. They are there for the expertise and the ability to extract a return in the marketplace that is different from a traditional index return. Commentators may have different opinions, but generally, although people are talking about growth in that trillion- dollar industry, there is a pause right now. Hedge fund returns challenging this year because the managers are not magicians — they cannot produce returns that are not there in the marketplace. Certain strategies may never come back and a hedge fund will look for new strategies for the future. I think we will see growth, but not to the extent that we have seen it in the past.
Mr. McGovern: If you divide the market into institutional participants and individual investors, the institutions that have historically favoured alternative investments are the U.S. endowments such as Harvard and Yale, which have fairly sophisticated trustees. They understand the system and process and were early to adopt hedge funds. We are now beginning to see many corporate plans involved in hedge funds as well, in part because of the yields. Their asset liability studies may indicate challenges for them in meeting their obligations to their employees; and they are also looking for the diversification properties that alternatives can give them — not only hedge funds but also real estate, oil and gas, timber, venture capital, private equity, et cetera.
Institutions have moved in this direction for prudent diversification and asset allocation reasons. On the retail and high net worth side, the rationale is more varied. Part of it is yield, obviously, with the rates so low. I am a veteran of the mutual fund industry, where there were investors who were referred to as ``GIC refugees'' — people who ran from GICs to mutual funds as rates fell and markets performed well. When markets did not perform well through the tech bubble, there was a combination of both declining yields and declining equity markets.
For individual investors and high net worth investors, who have been the bedrock of the alternative industry for decades internationally, part of the impetus is pure fear. They do not want to subject their capital to the vagaries of the market. It is a combination of yields, fear of other asset classes and the need for diversification.
Good financial planners, such as well-run endowments and corporate plans, will see this as something to put into their portfolios. They might find that this year they are not doing great, but the bond and equity markets have not done well either. As Mr. Ostoich said, hedge fund managers are not magicians; they need opportunities just like any other market managers.
Senator Meighen: One phrase you did not use was ``market volatility.'' Does a hedge fund prosper in a volatile market?
Mr. McGovern: Yes, it does. There are about 25 different sub-strategies. My day job is working at a fund of funds. We see an inordinate number of managers and strategies from all over the world, and a good number of those strategies are focused on market volatility. These managers try to purchase volatility; and if you understand how to do that, you are in the top 1 per cent. Essentially, it is about buying volatility cheaply, assuming that some kind of event will occur in the market so that the volatility expands. People get nervous when that happens and sell; so if you are a buyer of volatility, you can make a great deal of money in that environment. That is why institutional investors like to invest in hedge funds. If you are an equity or a debt investor, you usually do not benefit by rising volatility; you normally lose money in those scenarios. This is a way to make money when the markets get choppy.
Senator Meighen: No less an authority than Mr. Greenspan agrees with you that after its rapid advance, the hedge fund industry could temporarily shrink and many wealthy fund managers and investors could become less wealthy. In his speech in Beijing, he said that hedge funds ``should not pose a threat to financial stability as long as lending banks manage their risk sensibly.''
It is human nature that we are all lemmings and banks are the biggest lemmings going. A few years ago, the big thing was sovereign loans; banks were shovelling out money to countries all over the world and lost a bundle in the process. Is there any reason to believe that with hedge funds being the fashion, banks are not shovelling out money indiscriminately and will not be caught?
Mr. Ostoich: The banks had a wake-up call in 1998 with Long-Term Capital Management, an infamous hedge fund in the United States that was leveraged to the hilt. It ended up close to complete liquidation until a number of banks were brought together to save it. The result was a President's working group paper in the U.S. that required banks to look at their counterparties, such as hedge funds and other parties in the marketplace, to ensure that leverage was under control. They are doing it much more in terms of that industry, monitoring who their counterparties are and the margin requirements to ensure to what extent monies are being lent. It is a similar kind of learning exercise as the experience in Canada, when banks were lending to real estate companies at high leverage; they learned a lesson from that.
The lesson in 1998 was good for global banks that participated. It has had a big effect in the marketplace in terms of what banks know about leverage in respect of hedge funds and other classes of investments. This goes to the principal- protected note market. If anyone can issue a principal-protected note, it is the banks because they have tremendous resources.
I have dealt with teams of people at banks dedicated to hedge funds only. If I were to pick one party to issue a note in the marketplace, it would be a bank. Banks can understand a complicated structure, can ensure that due diligence is practised and have the credit to support the note. They are perfect for that.
Senator Massicotte: The Bank of Canada is doing a study right now to determine the potential consequences at the extreme. I will let the bank and the Office of the Superintendent of Financial Institutions of Canada, OSFI, decide how to manage the prudence issue. My question related to the many investors who are either exempt or sophisticated: What do they expect? The old securities law would suggest that for those investors, it is ``buyer beware''; there is no need for rules or regulatory disclosure.
Obviously, AIMA supports that approach for the large and/or sophisticated buyer, that there should be no minimum form of disclosure or understanding other than the registration of the dealer and the ethical aspects.
Mr. Ostoich: I believe that there is adequate regulation in place. The SEC has gone through months of debate on regulating hedge funds; and Canadian provinces have had it for years, if not decades. Canadian hedge fund managers are similar to mutual fund managers; the actual manager is regulated by provincial authority.
Senator Massicotte: My understanding of this regulation is that you must be registered. However, in some provinces you must file financial statements and in some provinces not; there is no standard form regarding disclosure of the investment type or standard format for the fees. It is the participant, rather than the form of investment, that is registered. Am I correct?
Mr. Ostoich: Yes. There is no standard form for the offering document. I am not saying that is a good thing, but it is similar to private equity that institutions buy and any type of high net worth product that goes to the individual stockholder.
Senator Massicotte: Is the investing public making comments as to the adequacy of that reporting? Is the sophisticated investor saying we do not agree there should be no minimum disclosure or format?
Mr. McGovern: With respect to the major institutions in Canada, there is a lot of disclosure, transparency and due diligence done.
The Deputy Chairman: You mean voluntarily?
Mr. McGovern: Voluntarily in the sense that if it is not provided, they will not make the investment. All of those things will be shared with that investor.
Senator Massicotte: You are depending on the fact that these people are sophisticated, and therefore will be fully knowledgeable of all the risks in terms of the conditions of their investments. I do not necessarily dispute that, but that is obviously the bottom-line question.
When you speak of Norshield, was that the one involved recently with Cinar?
Mr. McGovern: That is right.
Senator Massicotte: You say in your disclosure that it is simply a runt of the fund. However, last week, I had a long discussion with a lawyer representing Richter, who I think has been appointed as a receiver, and it seems to be much more than that — it is basically fraud.
Mr. Ostoich: We are just going by what is being said in the public press in terms of Norshield.
Senator Massicotte: Even if Norshield is fraud or misrepresentation, I presume your argument would be ``buyer beware.'' These were sophisticated investors who knew what they were doing; life is full of risks and they should have been aware of the risks they were taking.
Mr. McGovern: Yes. If that is the case, it would be unfortunate, but these things happen from time to time. In the international marketplace, we have Lancer and Manhattan; it is easy to name off the ones that were not good experiences.
However, these are exceptions to the rule — there are thousands of hedge funds that have done a good job for investors. When you look at the money flow from institutions into these strategies, it speaks volumes as to the quality of the people that are engaged in the marketplace.
Like any industry, you are going to have a few folks that are not up to snuff. It behooves the institution or the investor to ferret that out. In any type of investment, you have to do that work.
Senator Massicotte: The good news is it tells people the funds are not all alike or equal, so make sure to do your due diligence.
Hedge funds were initially created to hedge risk. Today, I would make the observation that it is a high-risk, high- return investment portfolio. Is that accurate?
Mr. McGovern: No, I would not support that. Hedge funds are different return streams and different risk streams associated with generating those returns. When people buy a stock, they are trying to earn the equity risk premium — when they buy a bond, it is the debt premium over government security. Hedge funds have different ways of earning different return streams. The problem with the definition is that there are hedge funds out there that do not hedge, that are levered and very aggressive.
Senator Massicotte: Most of them are levered, with the exception of retail products, are they not?
Mr. McGovern: No. There are two different forms of leverage. There is accounting leverage, which is how big my balance sheet is; and there is risk leverage, which is how much exposure do I have to any specific thing?
For example, I could have a long/short equity manager; that is a very popular strategy in Canada. Typically, they would have something like 130 to 150 per cent exposure to the market, which might be 80 per cent long and 60 per cent short. Therefore, my net market exposure is 20 per cent, but I have taken on some margin within the IDA and government limits. The investor is buying manager risk from me, paying for the fact that I know how to pick stocks, long and short. He or she is not paying me to earn the equity risk premium because I only have 20 per cent market exposure there.
It is a very different proposition, and it is one that is valuable to the investor if the manager has skill. This is one of reasons why the fund of funds approach has been so popular. There are professional allocators that try to find these managers and mitigate the idiosyncratic risk of investing with only one hedge fund.
If you invest in a single hedge fund, it is akin to investing in one stock. As Mr. Ostoich said, the hedge fund manager is not a magician; he has a balance sheet and an income statement and he tries to earn returns. With a fund of funds, you spread that idiosyncratic risk over 20 or 25 different hedge funds and strategies, which is very useful for a portfolio
Senator Plamondon: You said you do not advertise on TV or over the radio. Where do you find those sophisticated individuals — are they referred by the banks? Also, how is the hedge fund manager regulated; and how do you measure the sophistication of a client?
Mr. Ostoich: In the case of hedge funds or any investment, it goes to the issue of who is bringing in an investor and whether proper due diligence has been done. On high net worth, there is typically an arms-length broker who tells a client, ``We have some printed information relating to a hedge fund; it looks like a good investment and maybe you should take a look at it and enter it into your portfolio.'' Typically, it is a third party broker who is going to get a commission out of that transaction.
Senator Plamondon: Is this commission apart from the 2 per cent that the hedge fund manager has and the 20 per cent on the return? How many fees like that are there?
Mr. Ostoich: It may or may not be. It can be, and usually is, an additional fee. That is not always the case, however; some managers take it out of their own 2 per cent.
On the hedge fund side, most would prefer to have no retail investors in their fund. They would rather have 10, 20 or 50 investors than deal with thousands of retail investors. When hedge funds go out in the marketplace and someone says, ``we want to raise capital for you,'' they are very guarded about giving up any of their fees. They would typically put an additional fee on that.
Senator Plamondon: Who does the customer analysis? Is it the broker or the hedge fund manager?
Mr. Ostoich: It is the broker. It is the person who is selling the hedge fund, which sometimes could be a hedge fund, but more often is the broker.
Senator Plamondon: Is he is the one who is regulated and has a permit from a provincial authority?
Mr. Ostoich: Exactly. The provincial securities commission regulates the hedge fund manager. In Ontario, it requires that the manager, just like a mutual fund manager, must be regulated as an investment counsellor or portfolio manager.
Senator Plamondon: Does the hedge fund manager need a permit?
Mr. Ostoich: A hedge fund manager is a portfolio manager, and receives a registration from a provincial commission. In Ontario, it needs to be renewed every year and is subject to proficiency.
Senator Plamondon: Are the obligations of the hedge fund manager different from those of the broker?
Mr. McGovern: There are two parties to the transaction. There is the manufacturer, or the hedge fund manager, and the intermediary, who is usually a broker-dealer, and the client is in the middle.
The manufacturers must be registered, and they are subject to various levels of regulation. The intermediary, as a fiduciary in the transaction, must adhere to the know-your-client rule and ensure that the investment is suitable for the customer. As well, every province has different regulations.
In Ontario, there are certain exemptions available. One of them is a minimum investment exemption, which means that if an investor must be prepared to put $150,000 into the fund to be allowed in, although the broker still must ensure that it is a suitable investment.
The second way you can buy the fund is by meeting the accredited investor test. In Ontario, that it means that the investor earns $200,000 a year, with the likelihood of continuing to earn that, or the investor and his or her spouse earn a combined income of $300,000. The third way to be allowed to buy the fund is by having $1 million of liquid net worth.
Senator Plamondon: That is not sophisticated.
Mr. McGovern: No, it is wealthy. It is the definition of an accredited investor. I think the rationale is that the person can afford to lose the investment.
Senator Plamondon: Are you saying that to be wealthy is to be sophisticated?
Mr. McGovern: I am not saying that; I am just saying that is the definition of an accredited investor. Is the term used in Quebec ``sophisticated?'' Most other jurisdictions use the term ``accredited,'' which simply means that you are wealthy.
Mr. Ostoich: It means that you have met a standard that the regulators have determined. The U.S. adopted a model like that years ago, and the Canadian provinces have adopted a similar model.
Senator Plamondon: It does not mean that you know anything about investing.
Mr. McGovern: That is correct.
Mr. Ostoich: You still rely on your broker as to whether this is a suitable product for you.
Mr. McGovern: If you are not accredited and do not meet the minimum investment threshold, certain provinces will exempt you if you are prepared to sign a risk acknowledgment form. For example, in B.C., if you are prepared to sign a form that says you know what you are doing and know that you could lose all your money, you can buy.
There are three basic things that the manufacturer relies on for a client to buy a hedge fund, and the intermediary has the responsibility to ensure that it is suitable for the customer.
The only other way that an individual investor can buy is through a principal-protected note. That is an obligation of the financial institution that falls outside of the domain of the securities commissions. It is commercial paper. Because the hedge fund is packaged in commercial paper, it is vetted by the bank and is subject to OSFI and Bank Act rules. The bank puts its name on it, so it does the due diligence; it ensures that the pricing, distribution and secondary markets are created and so on.
The Deputy Chairman: Even though it is a guaranteed protection, you will get your initial principal back less all these fees.
Mr. McGovern: The other fees related to principal-protected notes are the fees of the bank.
The Deputy Chairman: The investor can still be out-of-pocket.
Mr. McGovern: Absolutely.
Mr. Ostoich: Principal-protected notes are used for many things, such as stock indices that may never come back. You are right that the fee has to be deducted from the return.
Senator Kelleher: I am involved with a monetary authority that has over 4,000 hedge funds, and I am concerned about the apparent lack of regulation, although this does not necessarily apply to Canada.
If I inherit $250,000 and want to invest it in a hedge fund, I would not know how to find those people. Second, if I do find them, is there a government regulatory body that affords me some form of protection?
Mr. Ostoich: There are government regulatory bodies that afford protection. You will have to purchase a hedge fund through a regulated intermediary. That intermediary could be your existing broker at one of the large brokerages, or it could be a limited market dealer who is also registered with the Ontario Securities Commission.
The intermediary has a statutory responsibility to ensure that this investment is suitable for you. If your $250,000 represents 95 per cent of your net worth and you want to invest $200,000 in a hedge fund, the broker should tell you that it is not a suitable investment for you. You could insist on buying it, but you will be buying it through an intermediary who is regulated.
The Deputy Chairman: He has the right to go directly to the fund; he wants to know how to find it.
Mr. Ostoich: The fund has to have someone within it that is regulated. The IDA report speaks of a limited market dealer registration in Ontario. That person, wearing a different hat, has a responsibility to know the client.
You could do the same thing with private equity or any type of investment. Every large financial institution has private equity transactions, which are not regulated. The adviser is not required to be regulated by the provincial authorities.
Senator Kelleher: That is one of my concerns.
Mr. Ostoich: I agree with you. The dividing line between the two is blurry. Our system has always required hedge fund advisers to be regulated.
To answer your question, someone has to advise you on it. Whether they do a proper job is another matter.
Senator Kelleher: If I buy shares with Imperial Oil, I get a share certificate at least. However, I do not understand what I get when I invest in ``a hedge fund.''
Mr. Ostoich: You may or may not get a certificate. With most domestic hedge funds, you would. If they are bought through a brokerage channel on FundServ, it is the same as with a mutual fund. With a mutual fund, you do not get a physical certificate. Typically, if you bought a hedge fund outside Canada, you would be issued a piece of paper that said, ``Here is evidence that you have purchased $200,000 worth of hedge funds.''
Mr. McGovern: The key issue when buying through an intermediary is that the intermediary has to be regulated. However, that does not mean the intermediary is sophisticated. One of AIMA's goals is to continue to educate; while much has been done, there is still more to do in terms of alternatives.
Some of the biggest endowments are not putting 100 per cent of their money into hedge funds; instead, it is in the magnitude of 15 per cent to 20 per cent. If an adviser says that you need to be 100 per cent in hedge funds, then that adviser clearly needs some education.
Senator Kelleher: I am not convinced about the soundness of hedge funds.
The Deputy Chairman: We will hear from the intermediary's self-regulating body in a few minutes. You indicated there is a blurry line between a private equity fund and a hedge fund. How would you characterize a private equity fund compared to a hedge fund, which you said is indefinable?
Mr. Ostoich: Mainly it is a question of involvement: Are you actively managing the investment pool or is it a more passive investment? In a private equity pool, people are investing in one or more companies underneath, so it is a more passive investment approach.
In either case, there is evaluation and oversight by the fund managers, who also practice due diligence when selecting investments; but hedge fund managers tend to be more active and aggressive in trading. Having said that, there are many large hedge funds globally that do the whole range.
The Deputy Chairman: The key word is ``private.'' Would it be fair to say that a private equity fund is a group of high net worth individuals who have pooled their resources and hired smart operators to find businesses in which to invest or to purchase?
Mr. McGovern: That market is much more dominated by institutions because the lock-up periods on the investment typically run five to 10 years. With a hedge fund, the liquidity requirements are generally lower than that. However, the entire fund investment community is much more active in the search for investments — shareholder activism crosses all the various investment lines.
Senator Massicotte: Is the equity fund one of your categories?
Mr. McGovern: Are you referring to long/short equity?
Senator Massicotte: When the chairman refers to what we call an ``equity fund,'' it actually falls within your definition of a hedge fund.
Senator Moore: Mr. McGovern, you mentioned that there were 190 hedge funds in Canada as of June 2004; are they all listed on the TSE?
Mr. McGovern: Most of them are private funds.
Senator Moore: How many are listed?
Mr. McGovern: There are three or four listed funds.
Mr. Ostoich: None of the advisers is listed, but a handful of them have a product that is listed. The actual adviser is similar to a mutual fund company.
Senator Moore: The adviser is registered in each province where business is conducted, but what about the fund he manages?
Mr. Ostoich: Only a very small number are listed on a stock exchange.
Senator Moore: With regard to leveraging, if there is a $100 million fund and manager needs $200 million to pursue an opportunity he has found, will he borrow the extra money from a source?
Mr. McGovern: The hedge fund usually has a prime broker. In the U.S., it might be Morgan Stanley or Goldman Sachs, or in Canada it might be the Royal Bank of Canada or the other major banks, and they will provide the manager with the credit to invest.
Senator Moore: The credit and lending is subject to due diligence.
Mr. McGovern: Yes, as well as regulation.
Senator Moore: How many funds of hedge funds are there?
Mr. McGovern: There are approximately 12 funds of hedge funds.
The Deputy Chairman: Does that include the 190 hedge funds?
Mr. McGovern: Yes; as the comments note, there are many small managers and a few large managers.
Senator Moore: Did hedge funds exist before 1990?
Mr. McGovern: Yes.
Senator Moore: Were they in Canada?
Mr. McGovern: There were probably a few. It depends whether it is defined as an organized entity. Bank prop desks have been around forever and they act like hedge funds; but most people attribute the first hedge funds to Mr. Alfred Jones in 1949. He started a basic long/short, what is now called a ``Jones Model'' hedge fund.
Senator Moore: Has anyone taken it another step, to a fund of fund of funds? If the fund of funds looks like the best way to hedge your bests, has someone gone to the third level?
Mr. McGovern: Yes.
Senator Moore: Has that occurred in Canada?
Mr. McGovern: Not that I am aware of, but in Switzerland they have several that they call ``3F'' funds.
Senator Moore: How do they perform compared to the others?
Mr. McGovern: I do not have any data on that. Generally, they are not well-received in the public, from what I understand.
Senator Moore: With regard to research analysts, the U.S. brokerage firms used to use research analysts for corporate research. The regulator has put an end to that, so I guess the hedge funds are an attractive place for these research people to find work. How is that being regulated so that they do not advise inappropriately, as occurred in the United States? How does Canada regulate that aspect to protect Canadian investors to ensure that advice from researchers is solid and not biased in any way that could result in a hefty return for the researcher?
Mr. McGovern: Again, I would use the analogy of the mutual fund industry. There are conflicts that need to be disclosed to the extent that the bank analyst will support a bank-sponsored product, and that conflict has to be addressed and pointed out to investors. Generally, there are a large number of independent fund-to-fund and hedge fund operators that could be recommended on their merits. I am not as familiar with the Canadian market as I am with the U.S. market — Goldman Sachs and Morgan Stanley, et cetera, and how they construct their fund of funds. They are careful to avoid those conflicts when they are making money indirectly promoting a hedge fund that they are servicing. They have to be clear on that conflict.
In terms of the quality of the research done, the practitioners that have been involved in the market for a reasonable amount of time and have good institutional and capital backing are capable of analyzing these investments and determining whether they are appropriate to put in their products. The marketplace will determine whether they are doing a good job or not; if they are not, the money will exit.
It is an important to note that when the money exits, that does not mean that it is a blow-up or something has gone wrong. There is just an orderly liquidation of the capital and it is returned to investors, which happens a lot.
Senator Moore: With regard to Norshield preventing any further redemptions from their funds pending an orderly liquidation of their underlying investments, what will happen there? Since Norshield has invested in a number of investments, will they now go bankrupt and into receivership? Does a receiver come in, sell it all off and try to recover enough; and what happens to the money they get back?
Mr. Ostoich: I can just talk generally about Norshield because I do not know enough about it.
Senator Moore: Whether it is Norshield or some other company.
Mr. Ostoich: If it was an offshore fund of funds, insolvency laws typically would apply to that company. A monitor would be appointed to go in and give notice to the underlying investments — which would be other hedge funds — to redeem. Depending on the underlying hedge fund investments, they will have different recourse on a redemption.
Sometimes redemptions allow them to take the physical shares underneath that fund rather than waiting for a cash- out. It is like a liquidation scenario, in which someone would move into a fund and liquidate the underlying investments as quickly as possible.
The Deputy Chairman: In the Norshield deal, I assume there were investors who had principal-protected notes, or PPNs, yet they have suspended redemptions. How does the guy get his guaranteed principal back?
Mr. Ostoich: If it is a true PPN — I mention ``true'' because there has been confusion with Portus, which is not a principal-protected note, according to what has been disclosed on the OSC website — and it is issued by a bank, that bank has the risk in terms of insuring that principal is returned. It might break the note early, which means it has broken a 10-year, zero-coupon bond early and you are going to get 60 cents because people want their money out early. However, the bank would be on the hook for the principal at maturity or at breakage before maturity.
The Deputy Chairman: With the help of these two fine gentlemen, we have set the table rather well for the IDA to shoot down some of the conventional wisdom that is out there. On behalf of our committee, I thank you both very much for a well-prepared and edifying presentation. Senator Massicotte has a final question.
Senator Massicotte: Are you aware of the submission we received from the Investment Dealers Association? It may be useful if we got the witnesses' comments before they leave us.
Mr. Ostoich: We support the recommendations of the IDA, which appeared on page four of their report. However, we would love to talk to people about some of the information relating to things in the body of the document.
Mr. McGovern: As Mr. Ostoich said, there were some portions of it that we would like to present the other side of the argument on, but we very much support these recommendations. If those five bullets had been worked on, we would not be talking about Portus today.
The Deputy Chairman: Mr. McGovern, if there are specific points that have not come out today and you want to drop us a line in the next week, we will take note of it in our report. Thank you very much.
I would like to welcome Mr. Paul Bourque and Mr. Louis Piergeti of the Investment Dealers Association of Canada to the Standing Senate Committee on Banking, Trade and Commerce. As you have heard, we have taken cognizance of your May 18 report and we are very interested in hearing your concerns.
If you could slant it toward the consumer protection aspect, it would be helpful to us in our study. Our general understanding is that you have concerns in terms of consumer protection because it has grown so much into the retail end.
Mr. Paul Bourque, Senior Vice-President Member Regulation, Investment Dealers Association of Canada: Thank you very much for inviting us to your meeting here today and for taking note of our report. It certainly achieved one of the purposes in preparing it, which was to get it out into the public realm and get a discussion going about the issues we were seeing.
Senator Moore, in answer to your question, 53 of the 191 hedge funds in Canada are funds of funds. That is on page 44 of our report, where we list a lot of the statistics relating to the nature of hedge funds in Canada.
In any event, my name is Paul Bourque, senior vice-president of the regulation division of the Investment Dealers Association of Canada. We regulate the 210 IDA member firms, and there are 24,000 registered employees in every province and territory in Canada. I am here today with Louis Piergeti, who is vice-president of financial compliance at the IDA. He was the chair of the committee that drafted the report that you have here today.
The report was prepared by the IDA in response to a request from our oversight committee, which is a committee of our board. Members of that committee were concerned over the increasing popularity of hedge fund products among retail investors.
Our objective in doing the report was to examine hedge fund activities in Canada, focusing on the activity of IDA member firms and their affiliates; and to identify any regulatory arbitrage or soft spots in securities legislation and regulation governing this kind of business.
Unlike mutual funds, hedge funds are sold under exemptions from securities laws. Theoretically, this would limit their investor base to sophisticated and affluent investors, as defined in the various securities acts, who are capable of protecting their own interests. However, our report has documented a widespread retail distribution that has resulted in a very rapid growth in hedge fund assets under management in Canada, particularly in the form of principal- protected notes, which are linked to hedge funds in terms of their returns.
The expansion into retail markets heightened our concern about several aspects of hedge fund products, including the applicable securities exemptions that are available. Two are of particular concern. One is the provincial exemption that equates accredited investors with a managed account. The other is the exemption provided for principal-protected notes or bank-guaranteed paper.
We are concerned about the exemptions, the marketing practices of hedge funds and dealers and the conflicts of interest that arise for the fund administrator, which is sometimes called a fund manager. I call it a ``fund administrator'' to make it clear that it is different from the portfolio manager. The portfolio manager investment counsellor is a registered individual in all provinces; the fund administrator is not, and that is an issue of concern for us.
We also are concerned about the high levels of fees for some products, especially principal-protected notes, the fact that some fees are not transparent, the ability of hedge fund managers to meet expectations raised in the marketing and the lack of disclosure of some hedge fund operations in their financial affairs as administered by the administrator.
Hedge funds products are exempt from most regulatory requirements, such as securities registration and distribution; anyone can sell a hedge fund, registered or not. They do fall within the ambit, jurisdiction and interest of the IDA because we have a very important concern about the suitability of products that are sold by our members. We must be concerned with the risks that arise to investors and advisers when they are trying to assess suitability and due diligence, given the problems that exist with transparency and regulatory oversight of the products being sold.
The Deputy Chairman: Are you saying that someone who is an expert in Canadian gold mining stocks might not be qualified to sell hedge funds? Is it that simple?
Mr. Bourque: You do not have to be registered to sell a product. Our report sets out some of the things we think we should do. We have set out five recommendations that we will pursue in partnership with the Canadian Securities Administrators. We met this morning with the Ontario Securities Commission to discuss some of our recommendations, particularly the ones that relate to referral fees and off-book transactions.
Mr. Piergeti will provide you with a little more detail on our report.
Mr. Louis Piergeti, Vice-President, Financial Compliance, Investment Dealers Association of Canada: Principal- protected notes are the fastest growing alternative investment product in Canada, accounting for more than 50 per cent of the $14.1 billion in hedge fund assets in Canada. PPNs guarantee investors their original investment back at the maturity of the investment, which can range from five to 11 years. Registration under the Securities Act is not required if it represents evidence of indebtedness issued by a government agency or guaranteed by a bank, trust, credit union or caisse populaire. However, PPNs are not protected by the Canadian Deposit Insurance Corporation in the event of the insolvency of the bank or trust company that issued them.
Based on Investor Economics, which is the primary source of many of the statistics in our study, the top three PPN issuers in Canada, based on assets, are the Caisse Populaire Desjardins, the Business Development Bank of Canada and the Canadian Wheat Board.
The fee structure of PPNs can make it difficult for a manager to produce returns beyond the guarantee. For example, if an investor buys $100 in a principal-protected hedge fund, the manager must invest $70, based on a discounted value and looking at 10 years to maturity, in low-risk security that will cover the principal protection on maturity. The manager then arranges to provide an investment adviser — the registrant — the remaining $30 to invest in hedge funds. It is the $30 investment and leverage on that investment, net of a myriad of fees that must be covered, including commissions paid to individuals that recommend those securities to clients; fees to set up the structure; management fees, which range from 2 per cent to 3 per cent; performance fees, which are as high as 20 per cent; prime brokerage commission fees for the underlying trading in the hedge funds; swap fees, which relate to how the fund or the investment in underlying hedge funds is structured; and all the underlying fees associated with the invested hedge funds themselves that must be covered to earn an absolute return on the $100 investment.
Not surprisingly, most PPNs follow an opportunistic strategy of alternative investment to generate big returns, a style that some describe as ``have a hunch, bet a bunch.'' The risk that investments locked in for as long as 10 years will earn zero return is no small risk to a retail investor.
I will conclude with a summary of the recommendations for IDA action. The IDA will provide more specific guidance to its members as to their gatekeeper responsibility in the intermediation of financial products sold to their clients, including product due diligence. The IDA will remind members of the prohibition against off-book transactions. The IDA will develop industry guidance on acceptable practices for referral arrangements. Currently, there can be confusion among financial intermediaries as to who is ultimately responsible for assessing the suitability of a product recommended to a client. With the small proportion of IDA members that manufacture and distribute hedge funds to their clients, the IDA is currently examining how these members manage their hedge fund activities, with emphasis on the inherent conflicts of interest and the multi-roles that they perform. This review will lead to a member regulation notice highlighting the best practices.
Finally, the IDA will draft bylaw changes to restrict conducting any securities-related activities away from the member firm under the guise of a limited market dealer registrant. These registrations have limited rules and create the opportunity for regulatory arbitrage.
Senator Meighen: In your report, you have included issues and concerns as well as recommendations. Do the recommendations cover all the issues and concerns?
Mr. Bourque: No, they do not. Many of the concerns we have raised relate to provincial securities legislation and are not things over which we have primary responsibility or control. We wanted to set out what we believe the issues to be, as well as the recommendations we have made for ourselves, and then to enter into discussions with the Canadian Securities Administrators on how we might help them review some aspects of the securities legislation, which is the process we started this morning in Toronto.
Senator Meighen: Can we reasonably expect that process will be pursued vigorously? When will we know that something has occurred?
Mr. Bourque: A small group will study the issue of referral fees and what a referral is, and they are to report back in two weeks. We hope to move quickly on several specific items that we think are long overdue for setting standards.
Senator Meighen: How effective is the Canadian Securities Administrators in coordinating and seeking to harmonize provincial regulations?
Mr. Bourque: As a national organization overseen by the 10 provincial regulators and 13 territorial regulators, you can understand that I do not answer that question easily. I think the CSA has made tremendous strides in harmonizing in a variety of area, including prospectus exemptions and registration exemptions. Having said that, we are all fully aware of some of the frailties of the current system.
Senator Meighen: I would suggest that cannot be solved through the Canadian Securities Administrators.
Mr. Bourque: I do not know whether I would agree with that. Issues have been dealt with successfully in the past, and we can do it again.
Senator Meighen: Is it a question of will, in your view?
The Deputy Chairman: It is a will to survive and avoid further regulation.
Senator Meighen: That brings me to the question of voluntary codes of practice and guidelines or regulatory requirements.
Is it a case of different situations requiring one or the other, or is one better than the other? What has been your experience?
Mr. Bourque: Both have a role. We have seen it in other areas. A good example is analyst standards, where we have IDA Policy 11, which was brought in a year and a half ago to deal with some of the issues alluded to earlier, conflicts between research analysts and their firms, their clients and the public.
We have brought in a mandatory rule, rather than a code of conduct. If you do not follow it, you will be disciplined. On the other hand, there are organizations like AIMA, which have codes of conduct, that also serve a valuable purpose, not only for IDA members but also for those that do the same kind of job who are not members.
Senator Meighen: What are the most crucial areas of oversight that should be addressed: registration requirements for fund managers, initial disclosure of activities, financial statement reporting requirements or fees?
Mr. Bourque: Two key areas that provincial regulators should look at are registration of fund administrators and the exemptions that currently exist for products like hedge funds, which get sold to retail investors. That includes the managed account exemption, which equates a credit investor with a managed account, and the exemption for bank- guaranteed paper.
Mr. Piergeti: To follow on that, there are no teeth in the multiple registrations that exist. One example is the limited market dealer category, which is a securities registration category in Ontario. There are no rules regarding the proficiency of the people that distribute these exempt products to clients and no capital rules. Yet, it is the exempt products that are being distributed primarily through limited market dealers.
If you are a mutual fund dealer, a member of the MFDA, you can only sell public mutual funds. That is the licence. However, MFDAs also have limited market dealer registration, which allows the same individual to sell an exempt product to the same clients even though they may not have the proficiency for assessing suitability based on complex products such as hedge funds.
Senator Meighen: Sophisticated investors are defined by the amount of money they are willing to lose or invest. Should we seek a better definition, or perhaps have two categories of investors — the non-sophisticated and the sophisticated — defined by a monetary value?
Mr. Bourque: You have to pick an amount or line around which to draw the definition. Whether the best one has been chosen or not, it is one that we are familiar with. I am sure there are others.
Senator Meighen: Could you not say, ``How many years have you invested? Have you invested before in such and such?''
Mr. Bourque: The analysis becomes more subjective and harder to manage and regulate. That is part of the reason we have very bright line tests.
Mr. Piergeti: What becomes key is the ability of a securities registrant to assess suitability of an investment for that client. To the extent there are registrants that do not have the suitability requirement, having the accredited investor rule is meaningless by itself; if they have the wherewithal to afford the investment, it is ``buyer beware.''
[Translation]
Senator Massicotte: When I look at your five recommendations, on page 4, I have the feeling that you insist on existing rules. Apart from enforcing the rules and ensuring that rules are enforced, I do not see any structural recommendation. Am I wrong?
[English]
Mr. Bourque: Your observation is correct. We are trying to strengthen rules that we currently have to provide better guidance on previously issued guidance, particularly in the area of referral fees; and the definition of referrals may get a new rule.
We have not made recommendations that you would characterize as structural because we were not recommending in the area of provincial legislation, which is where structural change would come in that area.
Senator Massicotte: You are owned by and represent the dealers. You have an important role — delegated by the OSFI and by some securities commissions — to also represent the interests of the industry. However, your starting point is that you represent your members' interests. If you look at your chart, you also act as a lobbyist representing your members' interests.
How much reliance should we put upon your recommendations as opposed to other organizations, which perhaps represent consumers and investors more independently?
Mr. Bourque: You have to look at our results in terms of the regulatory actions we have taken over time and make your own assessment.
We have a mandate to protect investors and to enhance sufficient capital markets, which is the same mandate that all the securities commissions have. We feel aligned with what they are doing.
In order to support the notion of trust, we are overseen comprehensively and frequently by the 10 provincial securities commissions through on-site audits we go through every year and reporting. In addition, all our bylaws are approved by all the CSA and all of our information on enforcement is reported on a quarterly basis to all CSA members. If there was a concern about our inability to pursue our public interest mandate, I have no doubt the CSA would alert us to that immediately.
Senator Massicotte: Let us talk about PPNs specifically. A retail investor can invest into a hedge fund that is PPN because it is deemed to be less risky. Is that correct?
The Deputy Chairman: It is only one product of the fund.
Mr. Piergeti: The underlying investment of the PPN — the $30 of the $100 example — is the investment in hedge funds themselves.
The other $70 is put aside in safe investments. Theoretically, if left alone, they will grow back to the original $100 investment over 10 years.
Senator Massicotte: However, you are guaranteeing the principal of the investment and that is why it is exempt. Am I correct?
Mr. Bourque: It is guaranteed by one of the defined institutions.
Mr. Piergeti: It is exempt because it is unconditionally guaranteed, either by a bank or by the government, if it is a government agency.
Senator Massicotte: Is the principal guaranteed at maturity of the investment term, which is often seven years or 10 years?
Mr. Piergeti: That is right.
Senator Massicotte: If it must be repaid prematurely, what is the applicable discount rate or the investment rate upon expiry? For example, we talked earlier about Norshield, which is in receivership. What would happen if that were a PPN?
Mr. Piergeti: If a client wants to get out of it, they allow redemption. The PPN would be calculated for its net asset value; the underlying hedge fund would be market valued and there might be some clawback of commissions paid.
Senator Massicotte: How is the PPN calculated, given that the principle is guaranteed after seven or 10 years? What is the rate of discount?
Mr. Piergeti: It would be a discounted value. Based on the $70 to be put aside, it equates to about 4 per cent over 11 years.
Senator Plamondon: I would like to talk about the hidden fees. I understood from the testimony before you that the 2 per cent and the 20 per cent on the return were the only fees charged, and that the broker's fee was taken out of the 2 per cent. What are the other fees that you mentioned, and how much do they benefit your members?
Mr. Piergeti: Our members are not issuers of principal-protected notes.
Senator Plamondon: What are the hidden fees and where do they go?
Mr. Piergeti: These fees are subtracted from the net asset value calculation of the principal-protected note. For example, the $30 that is set aside can be leveraged up to 300 per cent. When you are dealing with leverage, you will have borrowing fees and other costs, including swap fees, which means that you give the $30 to a fund adviser and you swap back the economic performance. You have to pay for that.
The underlying investments in the hedge funds have a separate structure of fees that are not transparent and are unknown. There are different layers of fees as you go down the chain.
Senator Plamondon: You are saying that the $70 is always put aside.
Mr. Piergeti: It is put aside and guaranteed.
Senator Plamondon: Does the client not receive a statement as to how much money has been charged on the $30?
Mr. Piergeti: Not necessarily; there is no financial statement required for a principal-protected note.
Senator Plamondon: Did you recommend that?
Mr. Piergeti: We recommended that principal-protected notes should come under the ambit of securities regulations and should meet the rules and terms of disclosure.
Senator Plamondon: In that way, people would know how much they are being charged.
Mr. Piergeti: Yes.
Senator Plamondon: I do not see anything in here about this.
Mr. Piergeti: Our point is that PPNs should not be exempt from securities registration. If they were to fall under securities registration, they would have to follow all the rules that apply to any kind of security.
Senator Plamondon: Would you give me an example of conflict of interest?
Mr. Piergeti: In Ontario, when you manufacture a hedge fund, you create a trust or a limited partnership. With any trust, you have to assign a trustee. In public mutual funds, that trustee is usually a trust company. In hedge funds, you might be exempted from being a commercial trust company under the Ontario Loans and Securities Act, section 213. You can appoint a private company to act as both the trustee and the fund administrator.
However, the adviser is a related company to that private company. They are actually managing the underlying fund because they are the ones who are providing the advice. The administrator performs all the financial accounting and manages the financial affairs, including calculations of the net asset value, all expenses, redemptions, purchases, et cetera. The adviser is the registrant. They are the portfolio manager and decide the investment style they will sue to manage a product. If they are a related company, there is an inherent conflict of interest; not only are you the manufacturer, you are also managing and advising on the product and you also may be the distributor. You can wear three hats, and if the internal conflicts of interest are not managed, there is potential abuse in terms of incorrectly pricing the securities in calculating the evaluation of securities underlying the fund.
Senator Plamondon: What do you recommend?
Mr. Piergeti: From a securities commission perspective, we are recommending that fund advisers be registered and be subject to active registration. We are reviewing all our IDA member firms that may act as both the manufacturer of and adviser to a hedge fund to see how they manage inherent conflicts of interest.
Senator Kelleher: Why are you going to all this trouble? Why do you think you have to look at this and develop rules and regulations?
Mr. Bourque: Our primary concern was the distribution of a product for sophisticated and accredited investors to people that, in our opinion, did not fit the description. For example, some retail investors were enabled to purchase a hedge fund product for much less than the minimum accredited investor amount, and did not have the household income defined in the Securities Act. That is a concern for these kinds of products, which do not have the same overlay of regulation. In our report, we always compare how the retail investor is treated in a public mutual fund versus a hedge fund. That is the distinction we are trying to draw.
Senator Kelleher: Two firms have gone bankrupt and there likely will be more as the hedge fund numbers increase. There have been no lawsuits yet, but governments, the securities commissions and the IDA have not been brought in. Are you concerned about the degree of risk that you are taking by developing a modicum of regulation?
Mr. Bourque: We face the threat of lawsuits all the time in our work, so this would not be anything new. The issue of our own liability is known and we will take care of that.
This new issue, and our concern about it, relates to the distribution of this product to retail investors and the ability of advisers, many of whom are employed by our members, to understand what they are selling and do the kind of suitability and due diligence that is necessary. The current environment makes it difficult for them to do that, which is one reason for our concern and recommendation, senator.
Senator Kelleher: It will be difficult to evaluate the level of sophistication that you require from these product managers.
Mr. Bourque: Some managers think that hedge funds should never be sold to retail investors.
Senator Kelleher: Are you cooperating with international organizations, particularly those that deal with offshore funds?
Mr. Bourque: Most of our international cooperation would come through the securities commissions, but we also have good relationships with the NASD, which is the American broker-dealer regulator,and the SEC in the United States.
Senator Kelleher: Is there a growing interest in regulations by regulatory bodies around the world?
Mr. Bourque: There is a growing interest in understanding the problem, how the market is changing and trying to devise appropriate regulation for it. Nobody is interested in regulation for its own sake.
Senator Moore: You mentioned that you met this morning with the Canadian Securities Administrators.
Mr. Bourque: With the Ontario Securities Commission.
Senator Moore: What relationship, if any, is there between the IDA and AIMA?
Mr. Piergeti: I have used AIMA quite a bit in terms of their hedge fund primer. It was a very good document for providing the educational layout of what a hedge fund is. Investor Economics provided a lot of information statistically on the depth and scope of the hedge fund market, and AIMA has done good work on corporate governance. In my document, I even included a copy of certain extracts dealing with conflicts of interest that they recommend in terms of good corporate governance and hedge fund management.
The difference is that AIMA is an association. They are promoting from a perspective of educating the public about what hedge funds are, but they have no regulatory teeth. They cannot enforce those corporate governance requirements on their membership.
Senator Moore: If you are creating a fund, you have obviously done the research, so I do not know how you are not the researcher as well. Then there is the manager, who is also the distributor. The manager is registered in the provinces but the administrator is not. Are any of the managers members of the IDA?
Mr. Piergeti: To the extent that the IDA firm is the manufacturer of its own hedge funds, yes, there are; there are about seven or eight of them that offer that service. We have over 200 firms, so that is a very small percentage.
Senator Moore: Who is the member of the IDA, the firm or the individual?
Mr. Piergeti: The firm is the member. When you are an adviser, you have the option of being under a category of registration called ``investment counsellor'' — portfolio manager with the securities registrants — or you can be a member of the investment dealer. It gives you the same scope of service.
To the extent they choose to become a member of our organization, they are subject to all our rules and regulations and can provide portfolio management advice.
Senator Moore: I was surprised to read the top three principal-protected note issuers in Canada — Caisses Populaires Desjardins, the Business Development Bank of Canada, and the Canadian Wheat Board. I am hearing banks from the other witnesses, and there is only one bank here, which is a quasi-government agency.
Mr. Piergeti: Banks are coming up the scale very quickly. It is only a matter of time before they supersede the other three organizations.
Senator Moore: With regard to your five recommendations, our previous witness, Mr. McGovern, said if those five bullets had been worked on, we would not be talking about Portus today. Do you agree?
Mr. Bourque: That is a difficult question to answer in a definitive way. I can tell you that IDA members were involved in Portus hardly at all. Of the total amount of the Portus product distributed, only 3 per cent was distributed by IDA members. That suggests there is a level of due diligence and suitability going on that would identify issues such as those in the Portus product.
Senator Moore: If hardly any of these fund people are members of the IDA, how do you regulate? How many people involved in the Portus case were IDA members who, with your urging, could have been responding to these five recommendations?
Mr. Bourque: In terms of Portus, there was $780 million sold and IDA members distributed $20 million of that, either through referral or directly.
[Translation]
Senator Massicotte: When the issuer of the PPN is the Caisse populaire Desjardins, the Business Development Bank of Canada or the Canadian Wheat Board, in that case it is not the manufacturer, but only an individual who went to these institutions and said: ``I need your guarantee.'' Do I understand this right?
[English]
To deal with Senator Moore's comments, the principal was guaranteed by the Canadian Wheat Board, the Business Development Bank of Canada and Caisses Populaires Desjardins. They are not the manager of the fund; it is just a case of someone saying to them, ``I am going to pay you a fee if you use your guarantee to provide this comfort.'' Is that right?
Mr. Piergeti: They are actually the issuer. There is a difference. When you are creating a hedge fund, you create a trust. You sell units of that trust and that is how you get money.
Those other organizations are basically issuers, just like Bell Canada will issue stock to raise monies for their treasury. The same has been done with these organizations. They receive the money and they will, in turn, provide $30 of it to —
Senator Massicotte: Are they the promoter per se of these funds?
Mr. Piergeti: Others are promoters. A promoter will go to one of these organizations and say, ``We want to use you as a facility, being an issuer, and we will manage the $30.''
Senator Massicotte: They are simply the financial institution offering the guarantee.
Mr. Piergeti: That is right.
Senator Massicotte: Why those three? It gives the impression you went to them because everybody else said no.
Mr. Piergeti: The fourth largest organization on that list, and I did not include it, was Portus. Technically, Portus was a trust; they were not a financial institution, so they should not have been classified. The anomaly was that they were so big in size that they were comparable to these other organizations.
Senator Massicotte: This just appears odd. You have no comments as to why?
Mr. Piergeti: We do not know why.
The Deputy Chairman: Thank you to all our witnesses. We have had an excellent two-hour session, which has probably raised more questions than have been answered. I should tell everybody, including our listeners on the Internet or CPAC, on June 16, Thursday, at 10:45 a.m., we will be having the retiring chairman of the OSC, Mr. David Brown, coming here. He has asked to attend and share his thoughts not only on the consumer issues generally in the financial services sector, but also including hedge funds.
The committee adjourned.